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Reinvestment rate risk analysis: a comment

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Abstract:

In a recent article, Dr Michael J. Crean (1993) asserts that reinvestment rates of interest must be explicitly taken into account when using internal rate of return (IRR) to compare mutually exclusive investment opportunities. To that end and to measure the risk perceived to be associated with reinvestment, Dr Crean presents two new concepts, namely the combined result of externally averaged numbers (CREAN) and the reinvestment rate risk ratio (R4). Presents a response to Dr Crean's article. Begins by showing that the bulk of Dr Crean's analysis is a reproduction of research that appeared in the finance literature more than two decades ago. It is also shown that variants of IRR which explicitly take reinvestment opportunities into account are of low economic validity. Such measures offer no benefit to naïve investors, since they are forced to assume that the spot rates of interest determined in the financial markets already incorporate a consensus view of future reinvestment opportunities. Selective investors are also not well served by such measures as the CREAN, as they (just like IRR) cannot be used as an absolute measure of investment attractiveness or to compare mutually exclusive alternatives in the absence of information on the market price of risk. Concludes by taking issue with Dr Crean's assertion that duration and the R4 should both be used to gauge and compare the attractiveness of investments.

Keywords: Investment; Risk

Document Type: Research Article

DOI: http://dx.doi.org/10.1108/14635789510099436

Publication date: April 1, 1995

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