Risk and Return Measures - Measures of Investment Return (Contd.)
- Real Return/Nominal Return - real return is nothing more than the nominal (gross) return adjusted for inflation. The formula reads as follows:
Real Return = (1+Nominal Return/1+Inflation Rate) -1 x 100
In calculating the real return, one should take care to use a realistic inflation rate with which to make the adjustment.
- Total Return - measures the change in value, adding or subtracting any cash flows divided by the initial investment.
- Risk-Adjusted Return - this return is adjusted for the risk taken which enables the investor to determine whether the return was worth the risk assumed to obtain it. Please refer to the Performance Measures discussion in Chapter 7 "Portfolio Development and Analysis" for a review of the calculation methodology and rationale behind the Sharpe, Treynor, Jensen and Information ratios.
- Holding Period Return (single period return) - used to evaluate how quickly an investment increases or decreases in value, it is the most basic calculation, at which one arrives by dividing the change in wealth by the initial investment. The formula reads as follows:
HPR = Ending Value of Investment-Beginning Value of Investment +/- Cash flows/Beginning Value of Investment
- Internal Rate of Return (IRR) - the earnings rate that equates a series of cash flows to the present value of a given investment. IRR assumes that the investment's cash flows will be reinvested at the investment's internal rate of return.
Proficiency in yield calculations is tested extensively, both for conceptual understanding as well as facility in performing the computation.
- Yield-to-Maturity (YTM) - the internal rate of return calculation used for fixed income. One may compute it using a financial calculator that performs time value of money calculations. The inputs are as follows: PV=present value of the security. CF=the size of each cash flows for the period in question. N= the number of cash flows to be evaluated. I=the IRR for which the candidate solves using all of the foregoing inputs.
- Yield-to-Call (YTC) - the internal rate of return calculation used for callable bonds. The assumption is that the cash flows are reinvested at the IRR until the bond is called. One would use the same methodology for yield to maturity to calculate the yield to call.
- Current Yield (CY) - the dollar value of the annual coupon divided by the bond's current market value. The follow example will illustrate this:
A corporate bond is paying 8% and is selling at $1,080. Its current yield is computed as follows: $80/$1080=7.4%
Remember that the annual coupon expressed in dollar terms is the bond's percentage multiplied by its par value (.08 x $1,000=$80)
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