Managerial Finance Volume 16 Number 1 1990
THE MATCHING OF ASSETS WITH LIABILITIES BY
GOAL PROGRAMMING.
E.S. Rosenbloom and Elias S.W.Shiu *
Department of Actuarial & Management Sciences, Faculty
of Management, University of Manitoba, Winnipeg, Mani­
toba, R3T 2N2, Canada.
* Support from the Great-West Life Assurance Company
is gratefully acknowledged.
Abstract.
A major problem facing the financial industry today is in­
terest rate fluctuations. An important technique for insu­
lating a fixed-income portfolio from shifts in the term
structure of interest rates is the method of cash-flow
matching. This method can be enhanced by allowing
carry forward and borrowing from future surpluses. Unfor­
tunately, the resulting mathematical program is non-linear.
In this paper, we show that the introduction of deviational
variables linearises the problem. As the decision maker
may have several incommensurable objectives, we pro­
pose a goal programming formulation as a realistic and
flexible model for this problem. The resulting model can
then be solved by using a standard operational research
computer package.
I. Introduction.
A major problem facing the financial industry today is in­
terest rate fluctuations. If assets are invested shorter than
the corresponding liabilities, reinvestment risk arises be­
cause interest rates can fall. On the other hand, if assets
are longer than liabilities, then liquidation risk or market risk
exists as interest rates can rise. Nearly half a century ago,
T. C. Koopmans [14] already pointed out that, in order to
reduce interest rate risk faced by a financial intermediary,
the maturity dates of the securities in the investment port­
folio should be related to the anticipated liability payments
and the two streams of cash flows should be matched peri­
od by period.
Two important methods for matching assets with lia­
bilities (so as to insulate the portfolio from shifts in the term
structure of interest rates) are cash-flow matching and im­
munisation. The term "immunisation" was coined by the
British actuary F.M.Redington[19]. Redington's theory is
to equate the mean term of the assets to that of the lia­
bilities while requiring the assets to be more spread out
than the liabilites. Redington's "mean term" had been an­
ticipated by F.R. Macaulay [16], whose "duration" is the
standard terminology today. Expositions on immunisation
theory can be found in the books [3,8,9,12 and 18]; some
recent papers are [1, 2, 20, 21 and 22].
In this paper we present a generalisation of the classi­
cal method of cash-flow matching and provide a goal pro­
gramming formulation for its practical implementation.
23
II. Cash-Flow Matching.
Suppose that a decision maker has a stream of liability ob­
ligations of amount L(t) to be paid at time t, t ≥ 0. These
liability cash flows {L(t)} are assumed to be fixed and cer­
tain. The decision maker faces the problem of construct­
ing from the currently available universe of non-callable
and default-free fixed-income securities a portfolio that will
meet his future liability payments. As the decision maker
has limited resources, he may try to seek an initial invest­
ment portfolio with minimum cost such that its cash flow
will at least meet the projected liability payment for each
and every period of the planning horizon.
Let P(j) denote the current price for one unit of the j -
th security and C(t,j) its cash flow at time t. Let N(j) denote
the number of units of the j-th security to be purchased.
The decision maker described above seeks to find the in­
vestment portfolio {N(j)} by minimising total cost
Thus, the problem can be formulated as a linear pro­
gram. Applications and numerical examples of this classi­
cal formulation can be found in [5], [6, Chapter 19], [7,
Chapter 6] and [8, Chapter 7]. Unfortunately, there are
deficiencies with this formulation. As excess cash flow in
one period is not modelled to be carried forward to a sub­
sequent period, the initial investment may be unnecessar­
ily high. Also, there is no provision for short-term
borrowing. In order to reduce investment cost, both posi­
tive and negative cash balances should be allowed. How­
ever, if the interest rate for borrowing is not the same as
that for investing, the mathematical program thus formu­
lated is non-linear. Luckily, with the use of deviational vari­
ables, a linear programming formulation is possible, as we
shall show in the next section.
Deviational variables are used in pre-emptive goal pro­
gramming, which is a very flexible technique. Suppose
that, besides trying to keep down the size of the initial in­
vestment, the decision maker wishes to have the final ac­
cumulated balance above a certain threshold and also
have the liability cash flows as closely matched with the
asset cash flows as possible. He may employ pre-emptive
goal programming to take into account of all these three
goals, as we shall show in Section IV.
24 Managerial Finance Volume 16 Number 1 1990

As a buy-and-hold strategy, cash-flow matching is (3.2) can be transformed into linear constraints. Consider
particularly suited to the decision maker who, in order to the linear equations:
obtain a superior rate of return, needs to invest in illiquid A(1)= d(1)+-d(1)-
assets such as private placement bonds. On the other
hand, if the decision maker employs the immunisation
method, he has to rebalance his portfolio continuously and (1+l 2 )d(1)+_(1+b 2 )d(1)- + ∆ (2) = d(2)+-d(2)-
hold liquid and marketable assets.
III. A Linear Programming Formulation.
For simplicity, the cash flows are assumed to occur at the (3.4)
end of each time period. Hence the values of t are 1,2,3,
... only. Define the net cash flow at time t as
(1 +l m _ 1 )d(m-2) + - (1 +bm_1)d(m-2)-+
+ ∆(m-1) = d ( m - 1 ) + - d ( m - 1 ) -
Let b t denote the borrowing rate for period t, i.e., from t-1 and the inequality
to t, and I t the lending rate for period t. Each b t should be (1+l m )d(m-1)+ -(1+b m )d(m-1)- (3.5)
larger than or equal to the corresponding It. To be prudent,
one would set b t to be the maximum of the probable inter­ + A(m) > 0.
est rates at time t and It to be the minimum of the probable The quantity d(t) represents the money borrowed at time
interest rates at time t. t from income at time t +1 while d(t) + represents money
lent at time t to time t + 1 . Constraints (3.4) and (3.5) corre­
Let V(t) denote the cumulative balance of the net cash spond to (3.2) and (3.3), respectively. Now,
flows up to time t. If V(t) is positive, it is carried forward to
the end of the next period at rate l t +1; otherwise, at rate
b t +1. Hence,

subject to (3.1), (3.4), (3.5), d(t) + ≥ O, d(t)-≥ O and NO)

> 0, for all t and j , is a linear program. When the linear pro-
gramissolved,at most one of d(1)- andd(1) + is non-zero;
at most one of d(2)- and d(2) + is non-zero; and so on.

As there are many computer packages of linear pro­

gramming available in the marketplace, the practical im­
plementation of this solution is not difficult.
IV. A Multiple-Objective Formulation.
In the last section, a non-linear problem is transformed into
a linear program by means of deviational variables, which
are usually associated with goal programming formula­
tions. Goal programming, originally introduced by Char-
nes and Cooper [4], is one of the most powerful and
successful methods in Management Science. This tech­
nique reflects Nobel laureate Herbert Simon's "satisficing"
approach to decision making [17]. In this approach, a set
of multiple goals replaces a single optimisation criterion.
Expositions on goal programming can be found in [10],
[11], [15] and [23]. The paper [24] has listed 240 articles
on goal programming.

The decision maker might find the single criterion of

minimising the initial investment too restrictive. Although
he would certainly want to keep his initial investment down,
he might be satisfied with not spending more than, say, £A.
In terms of a goal programming formulation, this corre­
sponds to the constraint:

Although this mathematical program is non-linear be­

cause of the either/or constraints (3.2), it is shown in [13] In (4.1) s+ and s are the overachievement and the under-
that, by means of deviational variables, the constraints achievement, respectively, of the goal of an initial invest-
Managerial Finance Volume 16 Number 1 1990
ment of £A. It is obvious that the decision maker would like
to minimise the overachievement s + . Therefore, one of his
goals can be stated as:
Goal 1: Minimise s + .
Another goal of the decision maker might be that the
liability cash flows match the asset cash flows as closely
as possible. This can be accomplished by minimising the
total amount of lending and borrowing, i.e.,
However, as the decision maker may be more concerned
with mismatching in the short term than in the long term,
he may reformulate Goal 2 as:
where {v t } are discount factors.
Constraint (3.5) requires the final balance to be non-
negative. Instead, the decision maker might want a final
balance of, say, £B as a goal. Defining d(m) + and d(m)-
as the over-achievement and under-achievement of this
goal leads to the constraint
(1+lm)d(m-1) + -(1+b m )d(m-l) +∆ (m)+d(m)-
d(m) + =B. (4.2)
The corresponding goal would be to minimise the under-
achievement d(m)", i.e.,
Goal 3: Minimise d(m)-.
One way to consider all three goals simultaneously is
to minimise the objective function
subject to (3.1), (3.4), (4.1), (4.2) and that the variables
{N(j), d(t) + , d(t)-, s + , s-} are non-negative. In (4.3), the
positive weights w1, W2, W3 are chosen to reflect the relative
emphasis the decision maker puts on the three goals. This
formulation is still a linear program. However, it may be
difficult to choose the proper weights if the decision maker
feels that the goals are incommensurable.
An alternative approach is for the decision maker to
prioritise the goals. First, solve the linear program with the
most important goal as its objective function. When the
program is solved, equate the objective function with the
optimal value and input the equation as an additional con­
straint. Then, solve the revised linear program with the
second most important goal as its objective function.
Thus, the new solution is one among those points optimis­
ing the most important goal that comes closest to satis­
fying the second most important goal. Equating the
optimal value with the objective function yields another
constraint. Finally, solve the modified linear program with
the least important goal as its objective function. This sol­
25
ution strategy is a pre-emptive goal programming formu­
lation [15, Chapter 13].
There is an extension of the simplex method, called
the goal programming simplex, for solving pre-emptive
goal programs directly. If computer software for the goal
programming simplex is not available, a goal program with
k goals can be solved by solving a sequence of k linear
programs.
V. Conclusion.
Cash-flow matching is an important tool for asset/liability
management. It is particularly appropriate for the decision
maker who invests in illiquid assets for achieving higher
yields. The goal programming formulation provides a flex­
ible and realistic framework for coping with the problem of
interest rate fluctuations.
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