Research
5) What are assumptions about the expected real return on TIPS, its volatility, and its correlation with the real return on the other asset classes? What is the correlation of TIPS with the proposed Policy Portfolio excluding TIPS?
HMC has assumed that the current real yield of 4% on TIPS is a good estimate of the real expected return for the future. This relies on the expectation that the current investment in TIPS will provide returns in the future that will be similar to its current earning. They are expected to provide a higher return than Treasury securities mainly because of their inflation protection characteristics.
The volatility on the other hand has been calculated using the historical data. It is calculated using the realised returns of the last 3 years. HMC assumed the results of only last 3 years to calculate standard deviation which they consider reliable for the future. HMC assumes TIPS to be the least risky investment after cash and considers it be a much safer investment than the domestic bonds which only gives 0.3% more return but are twice as much risky.
HMC when calculating the correlation between TIPS and other securities assumes the relationship between them to be linear. It has a positive correlation with all the other assets except for foreign Equity and cash. The strength of positive correlation is the highest with domestic bonds of 0.5. This is mainly due to the fact that both investments are sensitive to the market interest rates and will behave similarly if interest rates change. The correlation on average with the all other assets excluding domestic bonds is 0.10 which is a weak positive relationship.
The volatility of the new policy portfolio without TIPS comes out to be almost 10% with a return of 6.6%. So without TIPS the portfolio is more risky while providing a little higher return and as a result has a lower Sharpe ratio without TIPS.
The correlation of TIPS with the new proposed policy portfolio without TIPS is low at
HMC has assumed that the current real yield of 4% on TIPS is a good estimate of the real expected return for the future. This relies on the expectation that the current investment in TIPS will provide returns in the future that will be similar to its current earning. They are expected to provide a higher return than Treasury securities mainly because of their inflation protection characteristics.
The volatility on the other hand has been calculated using the historical data. It is calculated using the realised returns of the last 3 years. HMC assumed the results of only last 3 years to calculate standard deviation which they consider reliable for the future. HMC assumes TIPS to be the least risky investment after cash and considers it be a much safer investment than the domestic bonds which only gives 0.3% more return but are twice as much risky.
HMC when calculating the correlation between TIPS and other securities assumes the relationship between them to be linear. It has a positive correlation with all the other assets except for foreign Equity and cash. The strength of positive correlation is the highest with domestic bonds of 0.5. This is mainly due to the fact that both investments are sensitive to the market interest rates and will behave similarly if interest rates change. The correlation on average with the all other assets excluding domestic bonds is 0.10 which is a weak positive relationship.
The volatility of the new policy portfolio without TIPS comes out to be almost 10% with a return of 6.6%. So without TIPS the portfolio is more risky while providing a little higher return and as a result has a lower Sharpe ratio without TIPS.
The correlation of TIPS with the new proposed policy portfolio without TIPS is low at