As a personal financial planner, one of your tasks is to prescribe the allocatio

Question

As a personal financial planner, one of your tasks is to prescribe the allocation of avail- able funds across money market securities, bonds, and mortgages. Your philosophy is to take positions in securities that will benefit most from your forecasted changes in eco- nomic conditions. As a result of a recent event in Japan, you expect that in the next month Japanese investors will reduce their investment in U.S. Treasury securities and shift most of their funds into Japanese securities. You expect that this shift in funds will persist for at least a few years. You believe this single event will have a major effect on economic factors in the United States, such as interest rates, exchange rates, and eco- nomic growth in the next month. Because the prices of securities in the United States are affected by these economic factors, you must determine how to revise your prescribed allocation of funds across securities.


Questions

1. How will U.S. interest rates be directly affected by the event (holding other factors equal)?
2. How will economic growth in the United States be affected by the event? How might this influence the values of securities?
3. Assume that day-to-day exchange rate movements are dictated primarily by the flow of funds between countries, especially international bond and money market transactions. How will exchange rates be affected by possible changes in the inter- national flow of funds that are caused by the event?
4. Using your answer to (1) only, explain how prices of U.S. money market securities, bonds, and mortgages will be affected.
5. Now use your answer to (2) along with your answer to (1) to assess the impact on security prices. Would prices of risky securities be affected more or less than those of risk-free securities with a similar maturity? Why?
6. Assume that for diversification purposes, you prescribe that at least 20 percent of an investor’s funds should be allocated to money market securities, to bonds, and to mortgages. That allows you to allocate the remaining 40 percent however you desire
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Part 3: Debt Security Markets
across those securities. Based on all the information you have about the event, prescribe the proper allocation of funds across the three types of U.S. securities. (Assume that the entire investment will be concentrated in U.S. securities.) Defend your prescription.
7. Would you recommend high-risk or low-risk money market securities? Would you recommend high-risk or low-risk bonds? Why?
8. Assume that you would consider recommending that as much as 20 percent of the funds be invested in foreign debt securities. Revise your prescription to include for- eign securities if you desire (identify the type of security and the country).
9. If the event of concern increased the demand for, instead of reducing the supply of, loanable funds in the United States, would the assessment of future interest rates be different? What about the general assessment of economic conditions? What about the general assessment of bond prices?

Explanation / Answer

Asset allocation is the process of determining the mix of stocks, bonds and other classes of investible assets to match the investor's risk capacity, which includes attitude towards risk, net income, net worth, knowledge about investing concepts and time horizon. Index funds capture assets in a low cost and tax efficient manner and are used to determine balanced portfolios. There are three methods of asset allocation: 1)Strategic allocation: It means that once the type of asset have been choosen, they do not change. This means you don't make any adjustments as to the economy or any other factor. 2) Tactical asset allocation: This invloves a periodic revision of asset allocation, inorder to improve returns and adjust for risk or both. It requires more time and effort to evaluate the economic conditions, market conditions an specific investments. 3) Dynamic asset allocation: This is primarily geared to the institutional investor. As the portfolio looses value, the risky assets are sold to buy the risk free assets. Influence of Exchange rate fluctuations:Changes in the value of a foreign currency denominating a bond affect theUS dollar cash flows generated from the bond and thereby affect the return to the US investor who invested in the bond. Consider a US financial institutions purchase of bond with a par value of 2 million pounds, 10% coupon rate (payable at the end of each year)currently priced at par value and with six years remaining until maturity. The dollar cash flows to be generated from this investment will differ in three scenarios. The cash flows in the last year also account for the principal payment. The sensitivity of the dollar cash flows to the pounds value is obvious. When interest rates are expected to rise, the bond can be sold and the proceeds can be used to purchase short-term securities whose market values are less influenced by interest rate moments. When interest rates are expected to fall, the bond portfolio can be expanded inorder to capitalize on the expectations. An aggressive approach offers greater potential for higher return but also exposes investors to more risk if the expectations go wrong. This is a classical example of interest rate risk. A risk takes prefers to invest in a risky asset similarly a risk averter prefers to choose to invest in risk free assets. Duration is also an important factor for investment. Short-term investments are considered to be less risky comparing to long term investments. Other things held constant. the higher the securities risk, the higher the return and if this situation does not hold prices will change to bring about the required situation. These price changes would in turn change the expected returns of the two securities. The difference in return would be a risk premium which represents an additional compenstion investors require for bearing higher risk.

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