US Government bond ETF - Investments Hedge Inflation and Interest Rate Risk - Accounting Assignment Answer

Internal Code: 1AFHEI

Accounting Assignment Answer

TASK: Assessment A client of your investment company has a 2bn US$ multi-asset portfolio under management with you. The client wants to make a significant change to the portfolio but is unsure what option from several to choose. The choices are whether to take a constant proportion portfolio insurance (CPPI), asset liability (AL), or risk parity (RP) approach to the overall security allocation, as well as whether to automatically re-set the investment weights at each year end or to have you make discretionary and deliberate active investment changes to the portfolio based on the relative valuations of securities. In order to make the decision, the client asks you to perform a back-test of each different portfolio approach. The client has set the following guidelines: For the CPPI back-test:

•  The safe portfolio comprises only a US Government bond ETF.
•  The risky portfolio has the following starting allocation: 20% emerging market equity ETF, 40% US equity ETF, 20% Europe equity ETF, 20% Japan equity ETF.
•  The maximum expected loss is to be calculated using the 95% confidence level. To calculate the maximum expected loss set the loss value at the 95% 2-tail confidence level for the whole time period. Calculate once at the beginning. Do not recalculate each year.
• The floor to not lose is US$ 1bn.

For the AL back-test:

•  The protection portfolio starts with US$ 1bn. Assume the investments hedge inflation and interest rate risk and will grow at an average annual 3% over time.
• The performance portfolio has the following starting allocation: 50% emerging market equity ETF, 50% world equity ETF.
•  Leverage is to be used. The maximum expected loss is to be calculated using the 95% confidence level. To calculate the maximum expected loss set the loss value at the 95% 2-tail confidence level for the whole time period. Calculate once at the beginning. Do not recalculate each year.
• Borrowing costs for the leverage shall be 1% per annum (ignore interest on interest).
• Show how much capital should be allocated to the performance portfolio after borrowing.
•  Show how much is set aside to fund the borrowing.

For the RP back-test:

•  The portfolio will comprise the following securities: US Government bond ETF, US equity ETF, Japan equity ETF.
• Set the risk (standard deviation) weights of each security for the whole time period and do not subsequently recalculate.
• Do not use any leverage or gearing.
• Ignore security covariances when forming the risk parity security allocation.

For the 3 approaches outlined above, calculate the following 3 back-test portfolios: 1. Passive. Set the appropriate starting allocation. The security weights are to naturally develop over time so make no further change. This is a passive reference portfolio or yardstick. 2. Rules-based. The starting allocation is as 1. above. At the close of 31st December each year, the rule is to re-set each security’s investment weight to the starting allocation. 3. Discretionary active. The starting allocation is as 1. above. Changes to security weights are then made according to relative valuation signals from relative valuation metrics developed by you. You decide the relative valuation signals and rules that instruct what is to happen when there is a signal.

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