Real returns, volatility

Exhibit 8.13 shows a scatterplot of average annual real returns against risk (the volatility of those real returns) since end-1981, for linkers, conventional gilts, equities, and gold. Gold has historically been regarded as the nltimate real asset. 

From market observation we know that index-linked bonds can experience considerable volatility in prices, similar to conventional bonds, and therefore, there is an element of volatility in the real yield return of these bonds. Traditional economic theory states that the level of real interest rates is cmistant however, in practice they do vary over time. In addition, there are liquidity and supply and demand factors that affect the market prices of index-linked bonds. In this chapter, we present analytical techniques that can be applied to index-linked bonds, the duration and volatility of index-linked bonds and the concept of the real interest rate term structure. Moreover, we show the valuation of inflation-linked bonds with different cash flow structures and embedded options. 

However, when holding linkers in a performance-based portfolio, rather than as a passively matched investment, short-time horizons become paramount. Real yields on inflation-linked bonds do change, creating short-term volatility in their real and nominal returns. 

The risk of an investment in securities is often defined as the volatility of prices or returns. The return is measured here as the sum of coupon income and price gains. From an investor s viewpoint it would be advantageous to hold a portfolio of securities the returns of which correlate as little as possible. In real life investors therefore try to keep correlations between securities in their portfolios as low as possible. Correlations for the database from 6/80 to 11/02 are all positive. They range from 0.66 (Treasury 10 year+ and BBB 1-3 years) to 0.99 (A 3-7 years and AA 3-7 years). ... 

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