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The Harvard Management Company and Inflation-Protected Bonds

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Group 5 The Harvard Management Company and Inflation-Protected Bonds Introduction The Harvard Management Company (HMC) is the organization that actively manages the assets of Harvard University. Overseeing a total of $19 billion in assets, HMC had managed to achieve an average real return of 11.3% during the 90's, 9.1% above the average return of US T-Bills and 3.6% below US equities. With a target of 6%-7% average real return, HMC'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 determine the relevance of each asset on its diversified portfolio, HMC is considering three factors: expected future returns, volatility of real returns and correlation of real returns on each asset class with those on all other asset classes. In Exhibit 1 of the report we observe the portfolio composition of Harvard's portfolio from 1984 until 2010. Through the use of historical data and mean-variance analysis, HMC was in a position to identify the portfolio that best suits its needs and considers making changes to it 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) ...read more.


US bonds decreased from 11% to 7% 3) Elimination of shorting cash from -5% to 0% 4) TIPS are introduced, representing 7% of the portfolio In the following graph we depict the efficient frontiers according to the portfolio optimization calculations presented in exhibits 5 and 6 of the case, under different sets of constraints. It is graphically confirmed that the proposed policy portfolio is superior to the current one, since it approaches the efficient frontiers. However, the fact that it does not lie on them suggests that there exist different asset allocations that can further improve the Policy Portfolio. Potential problems with the analysis In mean-variance analysis, the accuracy of estimates for the means and covariance matrix of assets is an important prerequisite. The HMC team only had three-year data for the performance of TIPS, so they relied on the real yield on TIPS (about 4%) within that period (1997-2000) to derive the expected real return on TIPS as well as covariance of TIPS with other asset classes. However, whether the performance of TIPS in this particular period is representative enough can be seriously doubted. As we can see from the graph of U.S. Annual Inflation Rate, there was a clear upward trend in inflation rate from 1997 to 2000, which probably contributed to the outperformance of TIPS to a large extent. ...read more.


Marketable index-linked debt was first issued in 1981. 3) Historical Inflation Appendix 1 In contrast, neither the principal nor the coupons on inflation-linked gilts are protected from deflation in the UK. 2 In the UK principal adjustments of inflation-linked gilts are not taxed. This gives inflation-linked gilts a tax advantage over nominal gilts, a larger share of whose cash flows come in the form of taxable nominal coupon payments. Markowitz Mean-Variance Analysis-Basic Model The underlying idea of the model: to minimize the variances of the portfolio given a target rate of return: (?ij: covariance between asset i and asset j; rbari: expected rate of return of asset i; rbar: target rate of return for the whole portfolio; ?i: portfolio weight of asset i) Using Lagrange Method to solve this problem: Setting the first-order derivatives of L with respect to each of the n weight variables ? to be 0 yields n equations, from which the optimal solutions to the problem can be derived: Suppose (rmin,?min) is the minimum variance point without any constraint on the portfolio rate of return. Then we can go ahead and graph all pairs (rbar, ?) in the minimum-variance set satisfying rbar >= rmin. This set of pairs is called the "Efficient Frontier". All portfolios on the efficient frontier are "efficient", in the sense that they all have the minimum portfolio variance given a certain target rate of return. ...read more.

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