Question

INVESTING YOUR OWN PORTFOLIO

You have won the jackpot of a European Lottery with a prize of €30 000. After distributing a portion of the prize to a local charity, you decide that it is a good idea to invest the rest of the prize. However, you are doubtful about which asset class or financial vehicle is more suitable given the current international context.

Bear in mind that you are in your early twenties and that your financial restrictions are negligible. While you are Not a Risk Lover, you feel comfortable with a portfolio with a high risk-reward profile. You seek professional advice and contact two recognized investment advisors.     

Investment Advice Summary

You had a virtual meeting with each of advisor and then you summed-up their financial advices as follows:

	Advisor 1	Advisor 2
Percentage invested in Bonds	85%	40%
Percentage invested in Equity	15%	60%
Investment Vehicle	Mutual Funds	Exchange Traded Funds (ETF)
Geographic Exposure	European Funds only	Global ETFs
Currency Exposure	Unhedged	80% FX-hedging into your local currency
Liquidity	Low to Moderate	High
Portfolio management style	Active	Passive
Rebalancing Frequency	Every six months	Every two years

2. Determinants of the level of interest:

Given that both advisors have recommended you allocate a portion of your portfolio into bonds, you wonder whether the ultra-low interest rates & unprecedented government policies will impact your return prospects. Analyze the effect of the following on the direction of level of interest rates and its impact on the value of bond portfolio: (5 points for each correct; total of 20 points)

1. Businesses become more pessimistic about future demand for their products and decide to reduce their capital spending.     
2. Households are induced to save more (or spend less) because of increased uncertainty about their future Social Security benefits.     
3. The Central Banks undertake open-market purchases of government securities in order to increase the supply of money.
4. The forward guidance signals that Central banks commit to keep the interest rates low for long (to avoid further market uncertainty and to boost economy).   

Answer 1

a. If investment decreases there is less bond supply, that makes the interest rate rises so bond price drops. The value of the bond portfolio decreases but the level of interest rates is higher.

b. If households save more, they will have more money available to invest, that would increase the demand for bonds what rises its price. The increases the value of the bond portfolio.

As interests behave in the oposite direction to price, the level of interest rates drops. This is because there is more money available for investors to borrow so the price they pay for money (interest rate) decreases.

c. If supply of money increases, the result is similar to B, there will be more money in the economy and some of that money will be saved and invested for example in bonds. That causes higher prices so bond portfolio value increases and lower interests.

d. Low interest rates expected discourages the bond demand due to the low returns at the current price. So price must increase to maintain attractive returns. That makes the bond portfolio value rise.