TIPS and Risk Management: How can you combine regular (nominal) Treasuries and TIPS to build a hedge portfolio that has exposure to inflation risk, but not to real interest risk?
To hedge bond portfolio that has exposure to inflation risk, one could simultaneously take long positions in TIPS and short positions in nominal Treasuries with equivalent terms to maturity. To be specific, if the inflation increases, TIPS are likely to outperform U.S. Treasury bonds with the same maturity. The difference between selling TIPS and buying T-bonds will cover the inflation risk losses thus effectively eliminates inflation risk in the portfolio.
The Harvard’s Policy Portfolio includes much of the university’s endowment, pension assets, working capital, and other specific assets, it reaches a total amount of $19 billion in year 2000. And the portfolio contains 11 wide asset classes, including domestic equity, foreign equity, private equity, domestic bonds, foreign bonds, emerging markets, real estate, commodities, absolute return, high yield, and cash.
This portfolio was determined by the board of the corporation for the long-run allocation, however, the manager can make short-run adjustment within the limits from the guideline.
The reason that HMS focus on real returns is HMS want to exclude the influence of inflation and determine the return rate more precisely. As the formula nominal return = real return + inflation rate shows, choosing real return instead of nominal return can reveal the real purchasing power of the investment, thus help the manager to conduct more efficiently to prevent the evasion of the investment.
As we can see from Exhibit 1and Exhibit 2, domestic and foreign equity constitute the biggest part of the portfolio, and these two asset classes have high real returns as well as relatively larger standard deviations. And we know that equity premium indicates the difference between the expected