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Hints
Hints
Instructions: In your groups, or as individuals, answer the following questions within the next several slides. Format is not critical
– ie, Power point or word doc is OK. Be ready to discuss in class on Thursday April 5, 2018.
2
Comparison of TIPS and Tbonds
• How does inflation affect cash flows of Tbond? TIPS?
• When do TIPS perform better than Tbonds?
• Interpret this expression
– Breakeven inflation = Tbond ytm – TIPS ytm
• How do the following affect prices of TIPS and Tbonds
– Increased real interest rate
– Increased actual inflation
– Increased expected inflation
– Increased inflation risk
3
TIPS vs. Tbonds comparison
• TIPS ytm is quoted in real terms, Tbond ytm is quoted in
nominal returns
• Example: suppose TIPS ytm = 1%,, Tbond = 2%
• How do we interpret the difference?
• Tbond ytm – TIPS ytm = 1% = what?
• What? = expected inflation + inflation risk premium
4
What is the Policy Portfolio
• And how is it determined
5
How does HMC develop assumptions
• Historical data + judgment
• Differences between historical and assumptions
6
What does HMC assume about TIPS
• Return, volatility, correlation with PP
7
Simple asset allocation intuition
• If HMC could invest in cash plus 1 other asset
– What asset(s) would you eliminate
– What asset would you choose
• Sharpe ratios for different asset classes
– These provides hints about the content of the optimal portfolio, but
they leave out one piece of critical information….what?
8
What does HMC assume about TIPS
• Eyeball approach
• Exhibit 1 gives current expected return and standard deviation
of PP
• Exhibit 4 gives expected return and standard deviation of TIPS
• Eyeball correlation of TIPS with PP…I used 0.15
• Now draw a two-asset diagram
9
Given assumptions, what is optimal TIPS
portfolio allocation
10