The Harvard Management Company and Inflation-Protected Bonds 1(a) Regular Treasury bonds are purchased at face value in the beginning or an adjusted price prior maturity. And in every period, normally annul or semiannual, investor will receive a coupon as an interest and at the maturity a principal plus coupon. (b) Coupon and principal of the Regular Treasury bonds are fixed, therefore if the inflation rate increases in the forecasting future, investor will receive the same amount of coupon and principal with less real value and purchasing power. (c)TIPS are simultaneously related to change of inflation rate which means the principal and coupon will adjust instantly to change of inflation rate. TIPS like Regular Treasury bonds respond to changes in interest rate, but unlike Regular Treasury bond, TIPS don’t have an expected inflation in the yield, its yield is related to actual inflation rate. (d)As we mentioned above that Regular Treasury bonds put expected inflation rate into calculation of yield, TIPS chooses actual inflation rate. Consequently, when actual inflation rate is higher than expected inflation rate, IPS outperforms regular Treasury bond. 2(a) if there is an increase in real interest rates, it would significantly reduce the price of TIP just as Regular Treasury bonds. Because when the real interest rates increase, investors tends to invest in something with higher return unless price of bonds decrease to compete with other investment. (b)TIPS are inflation-indexed bonds, so when price of TIPS would increase as long as realized inflation increases. (c)Expected inflation is not going to have any impact on TIPS, Because TIPS are responding to the actual inflation. (d)An increase in inflation risk is not going to increase the price of TIPS as TIPS would adjust price with inflation. (e)Like TIPS, a regular bond will have the same response to changes in real interest rates, but it would not change price according to change in realized...

...The HarvardManagementCompany and InflationProtectedBonds
Executive Summary
The HarvardManagementCompany (HMC) was established in 1974 with the goals providing world-class investment management focused solely on generating strong results to support the educational and research objectives of Harvard University. The company’s goals are to correctly measure Harvard University’s financial requirements and to provide investment opportunities that will accurately meet or exceed them with the lowest amount of risk assumed by the institution.
In order to best meet these investment needs the HarvardManagementCompany must continually revise the Harvard Policy Portfolio, which denotes how assets will be allocated across all available asset classes. This is necessary because new information in the market allows HMC to be more efficient in their investment strategies. Changes to this Policy Portfolio are made only in response to (1) changes in the goals or risk tolerance of the university as an institution, (2) changes in capital market assumptions, or (3) the appearance of a new asset class in the market.
Recently, reasons 2 and 3 were met in order to call for a new proposal to the Harvard Policy Portfolio. The introduction...

...The HarvardManagementCompany and InflationProtectedBonds
The HarvardManagementCompany is an entity wholly owned by Harvard University and it is responsible for managing Harvard’s endowment and pension assets. At the end of the second quarter of 2000, HarvardManagement Co. oversaw the management of $19 billion, the majority of it managed internally by Harvard’s investment professionals. The endowment’s goal is to provide a real return of 6%-7%, of which 4%-5% would be distributed annually to the university and the balance of returns would remain to allow for a real growth rate of spending. As of the second quarter of 2000, Harvard was actively considering creating an allocation to Treasury InflationProtected Securities (TIPS) in its Policy Portfolio. Harvard believed the portfolio weights should be changed due to changes in capital market assumptions and the rise of TIPS as an institutional-level investment.
TIPS Versus Nominal Treasury Bonds
Like many institutional portfolios, Harvard’s portfolio contained an 11% target allocation to domestic bonds. Including US Treasury securities as substantial portion of this allocation would allow Harvard to earn a market return on a fixed...

...Basic:
1. Why does Harvard spend so many resources managing its endowment? Why not simply invest in Treasury Bonds and be done?
2. Why this emphasis on real returns as opposed to nominal returns?
3.How does HMC form its capital market assumptions? Why don’t they use past statistics to project the future? What do HMC’s capital market assumptions imply about the forward looking domestic equity premium? How does it compare to the historical equity premium?
4.If cash has zero standard deviation and correlation with the other assets and an expected return of 3.5%, what kind of asset is it? Is it really risk-free?
5.Take the HMC management’s views of expected returns, standard deviation, and covariance of real returns as correct. Also, assume that cash is riskless (i.e. zero variance and covariance). If the board allows HMC to invest in only one asset class, which asset classes would you advise HMC to discard right away? Why?
6.If the board allows HMC to invest in assumed riskless cash and one other asset class, which asset class would you advise them to invest in? Why?
Advanced:
1. Suppose the board allows HMC to invest only in domestic equities and domestic bonds, arguing that they are “safe choices” in the sense that these assets are well-known to investors and they have deep, liquid markets. What combination of domestic bonds and equities would you pick?
2. Would you advise them to add commodities to the...

...short-term and long-term historical records and talked with investment management firms specialized in this type of analysis in order to get the most accurate data. Finally, HMC is doing well using the optimizer as a proxy for the investment decision. Optimizers may lead to completely different investment strategies if the inputs (mean, variance, correlation) are to be changed by a small amount. In a first step optimization, Meyer and his team found out they had to take substantial position in non-traditional asset classes. They therefore constrained the optimization in a second step, which led to a more realistic and implementable Policy Portfolio. How does HMC develop its capital market assumptions? Why does HMC focus on real returns? What do HMC’s capital market assumptions imply about the U.S. equity premium and foreign equity premium? As mentioned above, HMC developed its capital market assumptions (returns, standard deviation of returns and correlation between class of assets) using historical data. They used both long-term and short-term historical data, alongside with experts’ opinion and thus adjusted the assumptions to the current market conditions. This approach seems to be appropriated - however since the data may be inaccurate, the optimization might in this regard yield useless results. Moreover, because HMC provides the major part of the budgets of individual schools of Harvard, the management has to preserve the...

...By focusing on real returns, it gives the concerned parties at Harvard a clear view over the purchasing power’s growth of the endowment.
c) From Exhibit 11 we can see that domestic and foreign equity yields the same real return, with a slightly higher standard deviation for the latter one. This would imply that they would be better off investing solely on domestic equities. However, under the 2.a assumptions, since they have a 0.6 correlation, foreign equities will be part of the optimal portfolio.
3 – By using the estimates of expected returns, standard deviations and covariances among the asset classes, I will create N weights for each asset summing up to 100% calculating the expected return and standard deviation of the N resulting portfolios. These weight will be given by setting the portfolio to the desired rate of return and minimize its variance.
4- By the introduction of constraints to limit the weight in risky (EM) and alternative assets (Exhibit 13), the efficient frontier will yield lower returns and restrict its diversification. The restrictions will have a big impact on the first order conditional, thus delivering weights far from real optimality.
5 – From the point of view of an average investor, TIPs may be a suitable solution. However, for HMC that counts with 45 investments professionals, there are some points worth to mention: a) TIPs are based on CPI, which is an outdated measure of inflation in the US. It may not reflect...

...As of June 2000, the endowment managed by HMC totaled approximately $18.2 billion. The annual spending from the endowment represented approximately 27% of the total budget of the university. In fiscal year 2000, total endowment spending by the schools was $556 million (or 4% of the value of the fund at the end of previous fiscal year). Each year the University's operational governing body considers the overall financial situation of the University and decides the dividend amount to schools.
The Average Spending Ratio from the Endowment is 4.6% (low 3.3% and high 5.6%)
Desired Real Return for the Endowment is 6-6.5%.
Annual Gifts to endowment is 1.5 % of the fund.
Asset Allocation Policy: Policy Portfolio is constructed by the management and then approved by the Board. Policy Portfolio is constructed according to long-term return and risk assumptions. However, portfolio managers have got flexibility in the short term to decide the asset allocation.
Risk Control: Risk Control was being made by stress testing method.
The Optimal Portfolio Allocation: HMC uses optimal portfolio allocation while constructing their portfolios. They are trying to find the best combination of risky assets to be mixed with safe assets to form the complete portfolio. The advantages of this approach for HMC are:
It is based on the real return (relative to CPI), risk (standard deviations), and correlations of twelve assets.
It uses an optimization algorithm which...

...The HarvardManagementCompany (2001) Case
You will design an excel spreadsheet that allows you to answer the following questions:
i) Given figures in Exhibits 4 and 11 what is the expected return and volatility of the policy portfolio?
ii) Find an efficient portfolio having the same expected return as the policy portfolio but lower volatility.
iii) Find an efficient portfolio having the same volatility as the policy portfolio but higher expected return.
iv) Repeat question ii using the constraints in Exhibit 13.
v) Repeat question iii using the constraints in Exhibit 13.
vi) Consider the following seven asset classes: Domestic Equity, Foreign Equity, Emerging Markets, Private Equity, Commodities, Inflation-Indexed Bonds, and Cash. Using HMC’s input assumptions (see Exhibit 11, and also using the constraints shown on Page 22, Exhibit 12), what would be the allocation across these seven security classes if HMC was looking for optimal portfolios that would have expected real returns of 4, 5, 6, 7, and 8%. For each of these cases, also show the resulting standard deviation of the portfolio, and the Sharpe (efficiency) ratio (see footnote a in Exhibit 12).
vii) Redo part (vi) but now constrain the minimum and maximum weights on the seven different asset classes using the constraints shown in Exhibit 13. It may not be possible to achieve some of the expected real returns you...

...BOND PROBLEM SOLUTIONS
1. Six years ago, The Corzine Company sold a 20-year bond issue with a 14 percent annual coupon rate and a 9 percent call premium. Today, Corzine called the bonds. The bonds originally were sold at their face value of $1,000. Compute the realized rate of return for investors who purchased the bonds when they were issued and who surrender them today in exchange for the call price.
PV = 1000; N = 6; PMT = 140; FV = 1090; CPT I/Y
I/Y = 15.02%
2. You just purchased a bond which matures in 5 years. The bond has a face value of $1,000, and has an 8 percent annual coupon. The bond has a current yield of 8.21 percent. What is the bond’s yield to maturity?
CURRENT YIELD = ANNUAL COUPON ( PV
0.0821 = 80 ( PV
PV = 80 ( 0.0821 = 974.42
N = 5; PMT = 80; FV=1000; PV = 974.42 CPT I/Y
I/Y = 8.65%
3. The Dass Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a $1,000 par value; and the coupon interest rate is 9 percent. What is the yield to maturity at a current market price of $829? Would you pay $829 for one of these bonds if you thought that the appropriate rate of return was 12 percent?
PV = 829; N = 4; FV = 1000; PMT =90; CPT I/Y
I/Y = 14.99%
YES, IF YOU THOUGHT THE APPROPRIATE RATE WAS 12%,...

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