1. How do regular Treasury bonds work? How does inflation affect them? How are TIPS different?

Why do TIPS (out) underperform regular treasuries?

A treasury bond is a marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years paying interest payments semi-annually and taxed only at the federal level. Treasury bonds are issued with a minimum denomination of $1,000
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Treasury bonds are available directly to the general public and transactions with the government are usually conducted through a limited number of primary dealers who bid for the bonds in an auction. These dealers then make the bonds available on an open market, where prices and yields are determined by market forces.

Buying Treasury bonds is not risk free. Bonds typically trade for less than their face value or par, which creates the yield for the bondholder. The total yield is the difference between the purchase price and the par value and the interest to be paid up to maturity. As the price of purchasing a bond increases, the yield to maturity decreases. Most bonds are not held to maturity, but are traded to generate profits on fluctuating market conditions. Thus the interest rate risk is the principle danger to the buyer. United States Treasury inflation-protected securities (TIPS) are a simple and effective way to eliminate inflation risk while providing a real rate of return guaranteed by the United States government. They are securities whose principal is tied to the Consumer Price Index. With inflation, the principal increases and it decreases with deflation. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater. TIPS can provide an economic benefit in the event that future inflation in the United States turns out to be higher than the bond market currently anticipates. If actual inflation is lower than the BEI rate, nominal bonds may outperform over the life of the bonds. In the long run, nominal returns should surpass the returns of TIPS by an amount equal to the cost of the inflation risk premium. The premium is the reward earned by investors in nominal .Treasury bonds for bearing inflation. Thus, the total return on a Treasury bond portfolio has tended to be slightly more volatile than that of a similar-maturity TIPS portfolio.

2. How can we combine regular (nominal) Treasuries and TIPS to build a hedge portfolio that has exposure to inflation risk but not to real interest risk?

In order to achieve the desired hedge effect of inflation risk exposure and real interest rate neutrality, one needs to take a long position in the inflation indexed TIPS issue with a given duration and at the same time take a short position in the ordinary nominal T-Bond with exactly the same duration.

Starting with a given change in the real interest rate. by the moment the variable of inflation is changed as well. What are HMC's assumptions about expected return. one could actually observe that the two securities will offset each other through its long/short positions (the directional effect does not play any role as TIPS and nominal bonds both represent a short position in the real interest rate) and leave the overall portfolio payoff profile unaffected by ensuring a hedged real interest rate position. filtered from any external. Based upon this dataset HMC then conducts a portfolio optimization analysis and constructs a so called efficient frontier. Finally. due to the short position taken for the nominal bond.g. Emerging Markets. Harvard Business Company noted that for the period from 1997 to late 1999. summing up all the effect from above. inflation and interest rate risk about TIPS? While conducting its research. thus providing the portfolio with a risk-decreasing factor. 25%. A second reason . and Foreign Bonds) might be affected by different macroeconomics variables and trends and therefore could underlie different actual or expected inflation rate assumptions. Foreign Equity. volatility. However. they estimated the instruments volatility and correlation with all other asset classes. How does HMC develop its capital market assumptions? HMC develop its capital market assumptions by means of investigating the risk and return characteristics of the asset classes. its standard deviations. Moreover. merely inflation caused returns this in turn further enhances the comparability of the international asset classes in the portfolio with each other due to the fact that HMC is invested on a global basis. 5. 2% to 4. Here. and correlations/covariance with each other HMC tries to come up with a systematic asset allocation which optimizes the trade-off between portfolio return variance minimization and given expected portfolio returns. which is indeed still exposed to the inflation factor. which shows the set of portfolio asset combinations with the lowest risk for a given level of return an investor would be willing to hold. the inflation protected issue will by its inherent nature still compensate for any change in the price level. one could as well observe some kind of hedge and inflation neutrality. Next. For this purpose the company retrieves data based upon real. one needs to investigate how a change in one of the two variables affecting nominal interest rates (real rate or inflation rate) would affect the overall payoff for the investor. 7.In order to test this hedge portfolio upon its effectiveness. global securities (e. HMC assumed an average real return of 4% for long-term investments. Taking into account the overall positive growth trend of these securities since their market introduction in 1997. TIPS experienced a real yield within the range of 3. Within the sample. obtaining the following results: the estimated standard deviation of 3% was incomparably lower than standard deviations of other assets (median of 12%). one could indeed achieve exactly the desired hedge portfolio of being exposed to inflation risk but not to real interest risk at the same time. the portfolio becomes effectively exposed with regards to price changes here. The rates of return are adjusted for the change in an economy s price level as the real rate of return better reflects dynamics of the underlying security. inflation adjusted measures ov a er long-run time horizon in order to gain statistical significant results for further analysis.

since the face value that is redeemed at maturity will never be less than the initial face value.Do TIPS have advantages / disadvantages beyond their mean-variance properties that make them attractive class for investors with long investment horizons y y y y TIPS is that they do not bear any inflation risk. The highest. In the long term. This usually happens if the actual inflation is far below the expected inflation. By holding TIPS.S. They are also protected against deflation. Their low risk profile. which already allocate a part of the yield to compensate investors for the inflation. make them a good asset class for a long term horizon. In such a circumstance. TIPS have less liquidity than normal Treasury Bonds as they are traded less often. during the 70 s. as op-posed to common Treasury Bonds. The reason for this has been attributed to the unprecedented and unexpectedly high inflation rates in U. Low correlation coefficients make them an attractive tool to diversify a portfolio. . an investor can be better off by holding normal bonds. Due to the risk for the issuer. Long term TIPS may be unavailable at a certain point of time. 9. 50% correlation between domestic bonds and inflation indexed bonds was caused by the structure of both instruments: both have the same underlying security. and having shorter maturities can alter the portfolio structure of a long term investor. extremely long term TIPS can be hard to obtain. it is possible to maintain an acceptable degree of performance for long term investments. Disadvantages y y y TIPS can be counterproductive if the actual Inflation rate remains below the Break Even Inflation rate (BEI). even compared with standard Treasury Bonds. stocks have outperformed bonds in the past century. even though the nominal value of money has decreased. in which safe returns are often considered a priority.why TIPS were a reasonable candidate for the company s diversified portfolio were low correlations with almost all other asset classes.