<\/p>\n
This exercise involves an analysis of general economic conditions or systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy. You are asked to determine in percentage terms an optimal allocation of $1,000,000 among the following three asset classes: U.S. equities, U.S. Treasury bonds, and cash. The goal is to maximize your expected return over the next 12 months. You are asked to write a 1-2 page paper providing your analysis of the asset classes\u2019 return prospects and your justification of your allocation of monies among them.<\/p>\n
Spreadsheets of Index returns are available at<\/p>\n
http:\/\/research.stlouisfed.org\/fred2\/series\/SP500\/downloaddata<\/a><\/p>\n and<\/p>\n https:\/\/finance.yahoo.com\/q\/hp?s=%5EGSPC+Historical+Prices<\/a><\/p>\n <\/p>\n <\/p>\n Finally, what are the implications of interest rate changes for the equity market? Here is one response to this question: http:\/\/www.investopedia.com\/articles\/06\/interestaffectsmarket.asp<\/a><\/p>\nWeb-based finance sites also customarily carry data on the S&P 500. For example, \u2013at Yahoo! Finance: http:\/\/finance.yahoo.com\/q?s=%5EGSPC<\/a><\/h2>\n
\u2013at CNNMoney.com: http:\/\/money.cnn.com\/data\/markets\/sandp\/<\/a>?<\/h2>\n
\u2013At MSN: http:\/\/moneycentral.msn.com\/detail\/stock_quote?Symbol=$INX<\/a><\/h2>\n
We can define long-term Treasury bonds as 30-year U.S. government bonds. Historical data on yields on debt claims are available from the Federal Reserve at http:\/\/www.federalreserve.gov\/releases\/h15\/data.htm<\/a>. For historical daily rates on the 30-year T-bond, defined as \u201cMarket yield on U.S. Treasury securities at 30-year constant maturity, quoted on investment basis\u201d go to http:\/\/www.federalreserve.gov\/releases\/h15\/data\/Business_day\/H15_TCMNOM_Y30.txt<\/a>.<\/h2>\n
Long-bond Treasury rates are also available from the following sites:<\/h2>\n
\u2014 http:\/\/www.ustreas.gov\/offices\/domestic-finance\/debt-management\/interest-rate\/yield.shtml<\/h2>\n
\u2014 http:\/\/www.bloomberg.com\/markets\/rates\/index.html<\/a><\/h2>\n
The third alternative is cash. Assume no return on that share of your monies held in cash.<\/h2>\n
This analysis necessarily involves your assessment of systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy over the next twelve months. Let\u2019s more fully define systematic risk. According to the textbook, systematic risk \u201c\u2026influences a large number of assets, each to a greater or lesser extent\u2026[and is] sometimes called market risk<\/em>\u2026Uncertainties about general economic conditions, such as GDP, interest rates, or inflation, are examples of systematic risks. These conditions affect nearly all companies to some degree\u201d (p. 340-341). Your task is to consider your investment alternatives in light of systematic risk expected over the coming year.<\/h2>\n
Your considerations about investing in U.S. equities will thus involve your determination of the near-term prospects for the U.S. economy and the implications of these prospects for U.S. equities.<\/h2>\n
A useful site for recent and upcoming U.S. macroeconomic data releases is http:\/\/www.bloomberg.com\/markets\/economic-calendar\/. Click on the highlighted report or \u201cConsensus\u201d next to any particular report to get data (either recently reported or the near-term consensus, respectively), the schedule of future data releases, and a definition. More generally, many other sites provide information on macroeconomic data, such as:<\/h2>\n
\u2014 http:\/\/info.wsj.com\/classroom\/Indicators\/guide.html<\/a><\/h2>\n
\u2014 http:\/\/www.bea.gov\/<\/a><\/h2>\n
\u2014 http:\/\/www.gpoaccess.gov\/indicators\/index.html<\/a><\/h2>\n
\u2014 http:\/\/research.stlouisfed.org\/fred2\/<\/a><\/h2>\n
<\/h2>\n
Finally, the decision to invest in 30-year U.S. T-bonds importantly involves expectations about future inflation and the term structure of interest rates, i.e., \u201cthe relationship between short- and long-term interest rates\u201d (p. 157). On p. 155-156 of the textbook the distinction is made between \u201creal\u201d interest rates and \u201cnominal\u201d interest rates. \u201cNominal\u201d interest rates are the rates that are quoted in the financial press; they are the rates at which we borrow and lend. Per the approximated Fisher equation (Eq. 5.6 on p. 157), the nominal rate includes the so-called inflation premium, h, so that the higher the expected inflation, h, the higher the nominal rate, all else equal. In considering longer-term T-bonds one must also be aware that, in addition to expected long-term inflation, there is greater interest rate risk: \u201c\u2026longer term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds\u201d (p. 158). Specifically, should interest rates increase, the market value of 30-year bonds will fall and the fall will be more dramatic for a 30-year T-bond than for a 10-year Treasury bond. Conversely, price gains from any drop in rates will be more dramatic the longer the term to maturity on a bond. One should also keep in mind that while in general longer-term rates are typically higher than short-term rates for the same level of overall risk, there have been occasions when the reverse is true, and the term structure of interest rates is inverted. (Please see Figure 5.5 on p. 157 on the historical relationship between long-term and short-term U.S. interest rates.) Finally, in finance we assume that there is no credit or default risk on Treasury securities. It is assumed that there is no risk that the U.S. government will fail to meet its outstanding debt obligations. This is, of course, not the case for corporate issuers.<\/h2>\n
Questions for Individual Asset Allocation Exercise:<\/h2>\n
1. Allocate your fictional $1,000,000 among the following three asset categories:<\/h2>\n