Harvard Management Case Study

Harvard Management Company Case I

Mission Statement

In realization of the recent success of a new asset class, the Harvard Management Team will determine whether Harvard Management Company should incorporate Treasury Inflation Protected Securities (TIPS) into its portfolio.

What are TIPS?

Treasury bonds are government issued debt securities. They work like a normal bond that pays coupon payments until the bond’s maturity. These securities are very liquid because of their supposed riskless nature. Many people consider these securities riskless because they are backed by the government, which means that they carry no credit or default risk. The types of risk that they are prone to are from inflation and changes in interest rates. The way that inflation affects Treasury bonds is that they erode the value of the bond’s coupons and principal. To hedge against a bond’s vulnerability to inflation, a new security was developed in 1997.

Treasury inflation-protected securities (TIPS) differ from regular T-bonds in that their returns compensates for inflation. These securities have principals that are linked to the consumer price index (CPI), which compensates for any increase in inflation. This means that you are earning a real return rate on your investment regardless of inflation. If inflation is high than expected, TIPS outperforms regular T-bonds because inflation devalues regular treasury securities. On the other hand, if inflation is lower than expected, TIPS will underperform T-bonds. In the chance that deflation occurs, the principal would be adjusted downward resulting in lower nominal interest payments. With TIPS, in a period of uncertainty for inflation, your investment will have inflation protection if prices rise, and if they fall or remain the same, you will still achieve your real return through coupon and principal...