IS THE FEAR OF INTEREST RATE VOLATILITY OVERRATED? A SIMULATION CASE STUDY OF BONDHOLDERS’ LONG-TERM RETURNS
Journal Title: European Journal of Business and Social Sciences - Year 2013, Vol 2, Issue 9
Abstract
In this article we propose a simple simulation case study with a specific pedagogical objective. Finance students often struggle to fully understand the difference between coupon rate and yield to maturity; they also seem to have difficulty comprehending the reinvestment rate assumption embedded in the bond pricing model. The simulation case discussed in this paper helps students attain a deeper understating of the reinvestment rate assumption and yield to maturity that would help them not only with cognizance of bonds underlying arithmetic but also with comprehension of related topics such as internal rate of return (IRR) in capital budgeting projects. We simulate cash in/outflows of an investor that makes fixed periodic contributions to her one-bond portfolio and liquidates her position after a decade (or a five-year period with semiannual coupon payments). Results suggest that longterm bond investors should not be unduly concerned with interest rate fluctuations for two reasons: first, the dollar costaveraging nature of steady contributions mitigates the downside risk; second, the opportunity to reinvest ‘guaranteed’ interest payments back in the portfolio helps in achieving higher holding period returns. Our simulation results indicate that long-term bond investors would have earned positive returns exceeding the rate of inflation, with the exception of 1971-81 period, regardless of the direction that the yield took in any particular decade. The 1971-81 period however was concurrent with extreme rise in the yield. In July 1981 the yield reached the all-time high of 15.84%. We show that in this decade the inflation-adjusted return is equal to -0.27% which is a small loss in magnitude compared to the gains in other decades.
Authors and Affiliations
Alex Meisami| Judd Leighton School of Business and Economics Indiana University South Bend 1700 Mishawaka Avenue, South Bend IN, USA 46634. *Corresponding author: ameisami@iusb.edu
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- EP ID EP10333
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