Question;Assignment:Equity Analyst Project: Individual Asset Allocation Exercise;Purpose;To enable the student to demonstrate proficiency;in the first stage of a top-down, three-stage valuation analysis: analysis of;investment prospects in the U.S. macroeconomy.;Overview;This individual assignment involves an analysis;of general economic conditions or systematic risk, i.e., the risk that affects;all industries and companies, in the U.S. macroeconomy. You will be 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 will;be asked to write a 1- to 2-page paper providing your analysis of the asset;classes' prospects and your justification of your allocation among them.;Action Items;1. Read the;Equity Analyst Project document that your professor will distribute during Week;1.;2. Conduct;any necessary research so that you can make a proper analysis.;3. Write a;1- to 2-page paper that provides your analysis of the three asset classes;prospects and your justification of your allocation among them. Format your;paper according theAcademic;Paper Guidelines.;Questions;for Individual Asset Allocation Exercise;1.;Allocate your fictional $1,000,000 among the;following three asset categories;Asset;U.S.;Equities;U.S.;30-Year Treasury Bonds;Cash;Allocation;100%;2.;Justify your allocation based on your outlook for;systematic risk in the U.S. economy over the next year.;Individual;Asset Allocation Exercise;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?;return prospects and your justification of your allocation of monies among;them.;First;consider historical returns on various asset classes in the U.S. Look at Figure;10.4 on p. 305 of your textbook. Also, in Table 10.2 on p. 312 you can see that;historically equities outperform bonds in terms of average return but they also;carry more risk as defined by their standard deviations. These historical;results show that on average the return on equities is highest but in some;specific years this may not be true. For example, look at Table 10.1 on pp. 308-309;and you can see that in three out of the five years from 2000 to 2004 the;annual return on large-company stocks (defined in the text as the S&P 500);was negative.;In;this exercise your investment horizon is one year. In considering your;allocation among U.S. equities, long-term Treasury bonds, and cash to maximize;your prospective return over the next twelve months, we might next more;precisely define these asset classes. We can define U.S. equities as the;Standard and Poor?s (S&P) composite index [?At present?includes 500 of the;largest (in terms of market value) stocks in the United States.? (p. 304)].;More detailed information is available directly from Standard & Poor?s:http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,0,0,0,0,0,0,0.html;Excel spreadsheets of Index returns dating from 2009 back to;the late 1980?s are available at;http://www2.standardandpoors.com/spf/xls/index/MONTHLY.xls.;Web-based finance sites also;customarily carry data on the S&P 500. For example, --at Yahoo!;Finance:http://finance.yahoo.com/q?s=%5EGSPC;--at CNNMoney.com:http://money.cnn.com/data/markets/sandp/?;--At MSN:http://moneycentral.msn.com/detail/stock_quote?Symbol=$INX;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;athttp://www.federalreserve.gov/releases/h15/data.htm. For;historical on the 30-year T-bond, defined as ?Market yield on U.S. Treasury;securities at 30-year constant maturity, quoted on investment basis" go to;http://www.federalreserve.gov/datadownload/Output.aspx?rel=H15&series=b56abb6d9cc35f28ccf86b8a0188e948&lastObs=&from=&to=&filetype=csv&label=include&layout=seriescolumn;Long-bond;Treasury rates are also available from the following sites;-- http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml;--http://www.bloomberg.com/markets/rates/index.html;The;third alternative is cash. Assume no return on that share of your monies held;in cash.;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?s more fully define systematic risk. According to the textbook, systematic;risk ??influences a large number of assets, each to a greater or lesser;extent?[and is] sometimes called market;risk?Uncertainties 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? (p. 343).;Your task is to consider your investment alternatives in light of systematic;risk expected over the coming year.;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.;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 ?Consensus? next to any particular report to;get data (either recently reported or the near-term consensus, respectively);the schedule of future data releases, a definition, and, importantly for our;purposes, a section entitled ?Why Do Investors Care?? More generally, many other sites provide;information on macroeconomic data, such as;-- http://info.wsj.com/classroom/Indicators/guide.html;-- http://www.bea.gov/;--http://www.gpoaccess.gov/indicators/index.html;--http://research.stlouisfed.org/fred2/;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., ?the relationship between short- and;long-term interest rates? (p. 162). On p. 161 of the textbook the distinction;is made between ?real? interest rates and ?nominal? interest rates. ?Nominal? 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. 5.4 on p. 162), 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: ??longer;term bonds have much greater risk of loss resulting from changes in interest;rates than do shorter-term bonds? (p. 164). 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. 163;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.;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;Questions;for Individual Asset Allocation Exercise;3.;Allocate your fictional $1,000,000 among the;following three asset categories;Asset;U.S.;Equities;U.S.;30-Year Treasury Bonds;Cash;Allocation;100%;4.;Justify your allocation based on your outlook for;systematic risk in the U.S. economy over the next year.;;For a brief history of the S&P 500 see http://www.cftech.com/BrainBank/FINANCE/SandP500Hist.html.
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