I am refering to one of the examples on SS8: Asset Allocation in Book 2 of Schweser 2014.
Example: Adjusting Global Allocation
Foundations Ltd., manages the portfolio of a large endowment fund with a strategic allocation of 70% to equities. The 70% is split with 40% in UK equities and the remaining 30% in international equity. The firm’s economics staff has made the following return projections. UK Equity with Long Term E® of 8% and Short Term E® of 4% International Equity with Long Term E® of 9% and Short Term E® of 7% CFA Question: 1. Calculate the long- and short-term expected return for equity. 2. The same portfolio normally holds a laddered portfolio of bonds as a 20% allocation to fixed income. A tactical band is established by policy of 5% around this (a maximum of 25% and a minimum of 1 5%). The current allocation is 20%. The portfolio manager expects the central bank to loosen monetary policy, resulting in a small reduction in real interest rates and a large increase in inflation expectations. The manager proposes to tactically move 1 Oo/o of the portfolio from bonds to alternative investments. Is the action appropriate? What other information should be considered? If the action is not appropriate, could it be made appropriate? How? Answer Given: 1. LT: (40/70)(8%) + (30/70)(9%) = 8.42% and ST: (40/70)(4%) + (30/70)(7%) = 5.29% My Queries: Why do we use 40/70 and 30/70 instead of using 40% and 30%? Can someone please clarify? 2. The small fall in real rates and large increase in inflation expectations will raise interest rates and reduce bond prices and returns. Reducing bond exposure may make sense, but a reduction from 20% to 10% is too large and exceeds the tactical band. The manager needs to compare the projected bond returns to alternative investment returns and consider the costs of the trade before making a smaller shift. The often high transaction cost and low liquidity of alternative investments makes this an important consideration. After this is done, the action may be appropriate. Change in risk should also be evaluated. My Queries:
Why does the small fall in real rates and large increase in inflation expectations raise interest rates? Can someone please explain this?