Introduction: Modern portfolio theories explain investment process in two steps. The first step is to analyze the security to assess the risk and return characteristics of the available investment alternatives. The second step is to select the portfolio which involves choosing the best possible portfolio from the set of feasible portfolios (Chandra, 2008). Even before the development of any portfolio theory intuitive investors were knew the benefit of diversification which is reflected in the traditional adage “do not put all your eggs in one basket”. Generally investors are risk averse, hence at first they do not want to take any risk and if they take risk then they want compensation for that.
However, they still try to diversify the risk by investing in different securities with various risk and return profiles. Investments in bonds or fixed income securities play a central role in diversifying the risk of a portfolio. Especially, in the current situation when equity market is going through historic level of price movements due to global crisis, the bonds are preferred over equity by most investors (Brière et al. May2009).
And that has led the yields of bonds to the historic low levels. Two-year Treasury bonds yield less than 1%. The 30-year bond was, as recently as January 2nd, yielding less than 3%. James Montier of Société Générale cites figures showing that ten-year Treasury yields have averaged just over 4.5% since 1798. Today they offer just 2.5% (Buttonwood, 2009). Investors have long realized that the relative attractiveness of bonds with different maturities and coupons depends not only on expected movements in the future interest rates but also on the uncertainty surrounding these moves.
This linkage suggests a relationship between the level of interest rate volatility and the shape of yield curve (Litterman et al. 1991). This report assesses the investment strategy that a moderate investor with an amount of 5,000,000 GB Pounds should adopt for three months period starting from 1st Feb 2009 to 1st May 2009. At first 10% amount of the fund is invested in one bond based on its risk and return profile and then rest amount is invested in other bonds to make the portfolio diversified. Investment Requirements: Followings are the investment requirements: The investment objective is to achieve a balance between Income and Capital GrowthThe client does not require immediate access to his funds and is classified in terms of risk appetite as a ‘moderate’ investorThere is a sum of £5,000,000 available for investmentInvestment Options: Before selecting the investment options the investor needs to consider following things: Investment horizon: Since the investment horizon in the current case is just for 3 months so, equity is not an option.
Equity is considered to be a long term investment option. So, bonds are the only option available with the investor.
Risk Aversion of Investor: The investor has moderate risk appetite, so he/she can go for investment in medium to long term maturity bonds which are more volatile than short term maturity bonds. But as the investment period is just for three months it would not be feasible to invest in long term maturity bonds as there may be more volatility in their return.