Foundations of Finance

Lecture Note 1: Performance of Securities

Professor Roberto Gomez Cram

NYU Stern

Spring 2023

Last update: January 23, 2024

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 Outline

▶ Discounting Basics
▶ Time value of money

▶ Present and Future values

▶ Perpetuities and Annuities

▶ Perpetuity: constant & growing

▶ Annuity: constant & growing

▶ Compounding
▶ Stated rates (e.g., APR) vs. compound interest (e.g., EAR).

▶ Holding period return

▶ Internal rate of return

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 Valuation Basics

▶ Pricing a security typically involves finding the value today (i.e.,

present value) of a future stream of possibly uncertain (risky)
cashflows
▶ A standard valuation approach is discounted cash flow (DCF)
analysis:
▶ Identify/forecast future cashflows

▶ Discount them to the present (adjust for timing)

▶ At the appropriate “discount rate” (adjust for risk)

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 Time Value of Money

▶ How do we adjust for timing?

▶ Assume guaranteed or “riskfree” cash flows

▶ Cannot simply add cashflows at different points in time as a dollar

in the future is not worth the same as a dollar today if money can
be invested at positive rates of interest:
▶ Interest rate: guaranteed rate of return on a riskfree investment

▶ Two basic mechanisms:

▶ compounding – what is the future value of a known amount today?

▶ discounting – what is the value today of a known future amount?

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 Future Value

▶ Future value: cash value of the security at specific date in the

future.

F V = P V (1 + r)T

▶ The Future Value consists of the Present Value (the

principal), Simple Interest, and Interest on Interest.

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 Future Value
▶ What is the Future Value of $1000 invested one year at an
annual rate of 5%?
−1000 FV
t=0 t=1

▶ F V = P V × (1 + r)T = 1000 × (1.05)1 = $1050

▶ What is the future value of $1,000 invested for two years at an

annual rate of 5%?

▶ F V = P V × (1 + r)T = 1000 × (1.05)2 = $1102.50

▶ The final payment can be decomposed as:

▶ 1102.50 = $1000 + 2 × .05 × $1000 + .05 × .05 × $1000

| {z } | {z } | {z }
principal Simple Interest Interest on Interest

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 Future value

▶ Compounding - what is the future value of a known amount

today?
▶ Eg: if you invest $100 in a bank account that pays 10% (riskfree)
interest per year, how much do you have after 4 years?
t=0 t=1 t=2 t=3 t=4
100 100×1.1= 110×1.1= 121×1.1= 133.1×1.1=
100×1.12 = 100×1.13 = 100×1.14 =
110 121 133.1 146.4

▶ In general: FV = PV × (1 + r)T

where FV is the future value, PV is the present value, r is the

annual interest rate and T is in number of years. In this example
compounding occurs once per year

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 The Composition of Interest over Time
Investor starts with an initial deposit of $1,000 (see red bars), where
the account pays 10% annual interest.

Exponential growth → “the miracle of compound interest”

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The Effect of Return (ie., r) on FV

Small differences in r → “Big differences in FV”

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Example: The Last Real Estate Bargain in
New York

▶ The Dutch West India Company dispatched the first permanent

settlers to Manhattan Island in 1624. They established the town of
New Amsterdam as more settlers arrived.

▶ In 1626, the fledgling town’s governor, Peter Minuit, bought

Manhattan—meaning “Island of Hills”—from the Canarsie tribe
for 24 dollars’ worth of beads and trinkets. New Yorkers often call
this the last real estate bargain in New York.

▶ Was it a bargain?

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Example: The Last Real Estate Bargain in
New York

▶ Was it a bargain?

▶ Suppose interest rates are 6%:

▶ F V = P V (1 + r)T = $24 × (1 + 0.06)395 = $237, 699, 364, 868.

▶ Suppose rates are 7%:

▶ F V = P V (1 + r)T = $24 × (1 + 0.07)395 = $9, 700, 707, 893, 678.

▶ A future value of 9.7 trillion!

▶ Is this a safe or risky investment?

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 Example: The Last Real Estate Bargain in
New York
“[A] forthcoming paper in Regional
Science and Urban Economics
estimates that in 2014, the
developable land in Manhattan
—excluding parks, roads, and
highways—was worth between
$1.54 and $1.95 trillion, for an
average of $1.74 trillion.

... The researchers (Jason Barr,

Fred Smith, and Sayali Kulkarni)
arrived at that number by
analyzing the prices of vacant
parcels of land in Manhattan.”

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 Present Value

▶ Present value: cash value of the security today, meaning, its

price.
FV
PV =
(1 + r)T

▶ The Present Value consists of the Future Value, Simple

Interest, and Interest on Interest.

▶ The discount factor a.k.a. present value factor is

1/(1 + r)T

▶ The discount factor tells us how to “discount back to the

present” future cashflows.

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 Present Value
▶ To receive $1000 in one year, how much should I invest
today at a rate of 5%?
−P V 1000
t=0 t=1

▶
FV $1000
PV = T
= = $952.38
(1 + r) 1 + 0.05
▶ To receive $1000 in two years, how much should I invest today at a
rate of 5%?

▶
FV $1000
PV = T
= = $907.03
(1 + r) (1 + 0.05)2
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 Discounting

Discounting – what is the value today of a known future amount?

▶ Eg: if you want to have $100 after 4 years, and the bank gives you
10% interest per year, how much do you need to put in the account
today?
t=0 t=1 t=2 t=3 t=4
y y×1.1 y×1.12 y×1.13 y×1.14 =100
y=100/1.14 =68.30

1
▶ In general PV = FV × (1+r)T

where, again, PV is the present value, FV is the future value and

1
(1+r)T
is the discount factor with annual interest rate r,
compounding annually over n number of years.

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 Present Value

▶ What determines the interest rate? This is a very hard

question!

▶ An interest rate is just the way to quote the relative value

of cash-flows at different points in time.

▶ In the above example, the price of a two year bond with face value
$1,000 was 907.03.

▶ Suppose someone said they would only require $850 to give you
$1000 in two years time. What do you do?

▶ Pricing of securities by arbitrage.

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 Questions answered by discounting

Anything involving valuation of cash flows arriving in different periods.

▶ How much do I need to save for retirement?

▶ Should I take the job offer with the higher salary, or the one with a
lower salary but an equity grant?

▶ My sister-in-law wants to sell her business. What is a fair price?

▶ What is this stock worth?

▶ What is this bond worth?

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Example: Comparing bids for a penthouse

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 Comparing bids for a penthouse

▶ Bid 1: pay $11m today

▶ Bid 2: pay $11.5m 1 year from now

Assume Bid 2 has no risk of failure and the risk-free rate of return
is 3%

▶ Step 1: Calculate present value of cash flows

P V ( Bid 1) = $11m
C1 $11.5
P V ( Bid 2) = (1+r)T = 1+0.03 = $11.17m

▶ Step 2: Accept the bid with the highest PV

PV(Bid 2) = 11.17m >11m = PV(Bid 1)

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 PV, FV, R, T are tied by Definition.

▶ If you know 3 of the 4, can you find the last one?

F V =P V (1 + r)T
FV
PV =
(1 + r)T
r =(F V /P V )1/T − 1
log PF VV


T =
log(1 + r)

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 Calculations
▶ If you invested $1,000 and received $1,500 after 4 years,
what was the interest rate? Solution: r = 10.66%

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 Calculations
▶ If you invested $1,000 at 8% and received $2500, for how
long did you invest? T = 11.90

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 Calculations
▶ You want to have $25,000 in five year’s time. Interest
rates are 2%. How much do you need to invest today?
Solution = $ 22,643.27

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Single Payment Security: Zero Coupon Bond

▶ Let’s now turn to the simplest fixed income asset: the zero coupon
bond, or simply a “zero”.

▶ How are zero coupon bonds created? Treasuries issued in

primary markets, coupons “stripped” and resold
separately.

▶ What is the price of a given zero?

C
PV =
(1 + r)T
▶ Lower interest rates =⇒ higher bond prices.

▶ Note the “pull to par” of prices as we approach maturity.

Also see Handout 1. 24 / 90

Single Payment Security: Zero Coupon Bond
▶ Prices of a zero coupon bond with face value $1000 maturing in
year 10. Calculations for yields of 2 and 5 percent.
1000.00 1000.00
980.39
961.17
952.38
942.32
923.85
905.73 907.03
900.00
887.97
870.56 863.84
853.49
836.76
820.35 822.70
PV

800.00
783.53

746.22

710.68
700.00
676.84

644.61
613.91
600.00
0 2 4 6 8 10
Year

Yield=2% Yield=5%

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 Multiple Payment Security

▶ A multiple payment bond is just a collection of zero

coupon bonds.

▶ Present value of cash flows C0 , C1 , C2 , ..., CT :

C1 C2 C3 CT
P V = C0 + 1
+ 2
+ 3
+ ... +
(1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + rT )T
▶ Note the Future Value of same cash-flow stream, assuming all ri
are the same:

F VT = C0 (1 + r)T + C1 (1 + r)T −1 + ... + CT

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 Example: Discounting Multiple Cash Flows
▶ In general, for any stream of cashflows, discount each year’s cash
flow separately and sum:
-Example (assuming r=10% pa):
t=1 t=2 t=3
Cash flows 100 50 80
Discount factor 1/1.1≈.909 1/1.12 ≈0.826 1/1.13 ≈0.751

100 50 80
PV = + 2
+ = 100 × 0.909 + 50 × 0.826 + 80 × 0.751
1.1 1.1 1.13
= 90.91 + 41.32 + 60.11
= 192.34

In Excel, you can use the NPV function (assuming the same discount
rate for all maturities).

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Example: Valuing a grain bin “trade”

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Perpetuities and annuities

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 Perpetuities and annuities

Timeline of cashflow streams (and a single discount rate for all

maturities):

With long cashflow streams, these calculations can become tedious . . .

luckily, there are some shortcuts

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 1. Perpetuities

Definition: “A Perpetuity is a financial asset that promises to pay a

fixed nominal amount C forever”

Time 0 1 2 3 ... Forever

Cash Flows 0 +$3000 +$3000 +$3000 ... +$3000

Example: Consider the case of the purchase of a security that

generates cash flows equal to $3,000 forever. If the interest rate is 10%,
what is the Present Value of the investment?

Bringing each cash flow at a time to PV would take forever—literally!

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 1. Perpetuities

Definition: “A Perpetuity is a financial asset that promises to pay a

fixed nominal amount C forever”

Time 0 1 2 3 ... Forever

Cash Flows 0 +$3000 +$3000 +$3000 ... +$3000

Instead of calculating the PV with long calculations, we can use the

short cut:
C $3000
P V0 = = = $30, 000
r 0.10

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 Perpetuity Timeline
▶ Draw the timeline of payments. Note that our definition
assumes the payment for t = 0 has already happened.
0 C C C C C C
t=0 1 2 3 4 5 6

▶ And calculate the present value of each of these payments:

C C C C C C
0 (1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 (1+r)6

t=0 1 2 3 4 5 6

▶ Therefore the present value of the entire stream of payments is:

∞
X C
PV =
(1 + r)i
i=1

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 Perpetuity aka Consol

▶ What is the Present Value?

∞ ∞ ∞  i
X C X 1 C X 1
PV = i
=C× i
= ×
(1 + r) (1 + r) 1+r 1+r
i=1 i=1 i=0

▶ By formula for geometric sums:

C 1 C
PV = × 1 = r
1 + r 1 − 1+r

Also see Handout 2.

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 Perpetuity Example

▶ Suppose that your cell phone plan costs 12 × $60 = $720 per year.
The interest rate at all maturities is 5% per year.

▶ What price would you be willing to pay for a “forever”

phone plan?
720
PV = = 14, 400
.05
▶ What if you’d like to endow a permanent scholarship at NYU
Stern? How much should you donate today? The interest rate at
all maturities is 3% per year and the scholarship equals 70,000.

70, 000
PV = = 2, 333, 333.3
.03

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 Perpetuity Example
▶ Consider a perpetuity that pays $1,000 annually forever,
however, only starting 10 years from now. Interest rates
are 5%. What is the PV?

▶ We can think of this security as a normal perpetuity, except that

each payment is delayed by 9-years. Recall that under our
convention, for a normal perpetuity the payments start with the
next period.

▶ Instead of the payments of $1, 000 each year, it’s as if you get the
1,000
payment of (1+.05) 9 every year.

▶ So the value of the perpetuity is:

1, 000/(1 + .05)9
PV = = 12, 892.18
.05

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 Perpetuity Example
▶ Another way of thinking about this problem is as follows. Start by
drawing the timeline:

0 0 0 0 0 0 0 1000 1000 1000

t=0 1 2 3 4 8 9 10 11 12

▶ Note that from the perspective of t = 9, the contract looks like a

regular perpetuity. Therefore, in period t = 9 the value is:
C 1000
P V9 = = = 20, 000
r .05

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 Perpetuity Example
▶ We saw that from the perspective of t = 9, the value of the
contract is 20, 000.

▶ We can now calculate the PV from perspective of t = 0 by

discounting back the 20, 000 to today:

P V = 20, 000/(1 + .05)9 = 12, 892.18

▶ Put differently, we can think of the value of this asset as the PV of

a single payment of 20, 000 at t = 9.

0 0 0 0 0 0 20000 0 0 0
t=0 1 2 3 4 8 9 10 11 12

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 Historical examples of Perpetuities
The oldest perpetuities that are still making interest payments were
issued in 1624 by the Hoogheemraadschap Lekdijk Bovendams

Currently, the bond pays interest of $11.34 annually.

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 Annuities

▶ An annuity is a financial asset that gives the right to receive a

constant cash-flow C for T periods starting one year from today.
Time 0 1 2 3 ... T T+1 ... Forever
Cash Flows 0 C C C ... C 0 ... 0

N
C C C X C
PV = 1
+ 2
+ · · · + T
=
(1 + r) (1 + r) (1 + r) (1 + r)T
n=1

Shortcut:
 
1 1
PV = C r − r(1+r)T

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 Annuities
▶ An annuity pays a fixed cash flow C for T periods.

▶ What is the Present Value of an annuity?

T T T −1  i
X C X 1 C X 1
PV = = C =
(1 + r)i (1 + r)i 1+r 1+r
i=1 i=1 i=0

▶ By formula for geometric sums:

 T
1 1
−
" #
C 1 1+r C C/(1 + r)T 1 − (1+r)T
PV = 1 = − =C
1 + r 1 − 1+r r r r
" 1 #
1− (1+r)T
=⇒ P V = |{z}
C
r
Payment | {z }
PV Factor
Also see Handout 2. 41 / 90
 Annuities
We can also derive the annuity PV formula using financial
reasoning.

▶ An annuity is the difference between two perpetuities

▶ The first perpetuity starts at t=1

▶ The second perpetuity starts at t=T+1

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 Annuities

So, PV of annuity must be the difference between the PV of

the two perpetuities!

C The 2nd perpetuity makes its

P V (1) = first payment at t=T+1. So,
r
C/r is its value brought to
1 C
P V (2) = t=T. We multiply it by
T
(1 + r) r 1/(1+r)T to bring it back to
t=0.
 
C 1 C 1 1
P V (1) − P V (2) = − =C −
r (1 + r)T r r r(1 + r)T
| {z }
Discount Factor

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 Example of an Annuity

Consider a 20 year mortgage. The annual payment is equal to $100,000.

If you were CFO of Barclays and the interest rates were 20%, what is
the maximum ammount you would lend given the annual payment
schedule? (Hint: you wouldn’t lend more than the PV of these cash
flows)

 
1 1
P V0 = C −
r r(1 + r)N
 
1 1
= $100, 000 ∗ −
0.2 0.2(1 + 0.2)20
= $487, 000

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 Second Example of an Annuity

▶ What is the most expensive car you can afford if:

▶ You have no cash on hand.

▶ You can afford $632 per month.

▶ The bank will lend to you at 1% per month.

▶ You want to have paid the loan in full in 48 months.

▶
" 1 # " 1
#
1− (1+r)T
1− (1+.01)48
P V =C = $632 ×
r .01
=$632 × 37.974 = $24, 000

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 3. Growing Perpetuities

▶ A Growing Perpetuity is a financial Asset that gives the right to

receive a cash flow growing at a rate equal to g forever.

Time 0 1 2 3 ... N ...

2 N −1
Cash Flows 0 C C × (1 + g) C × (1 + g) ... C × (1 + g) ...

∞
C C × (1 + g) C × (1 + g)2 X Cn (1 + g)n−
P V0 = + + + · · · =
(1 + r) (1 + r)2 (1 + r)3 (1 + r)n
n=1
C
=
r−g

C
Shortcut: PV = r−g

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 Example: Growing Perpetuities

▶ Consider the case of the purchase of a security that will generate a

cash flow of $3k this year, growing at 2% per year forever. If the
interest rate is 10%, what is the NPV of the investment?

Time 0 1 2 3 ... Forever

Cash Flows $3k $3k(1.02) $3k(1.02)
2
... ...

▶ The stream of cash flows equal to $3,000 starting in period 1 and

growing at a constant rate forever is a growing perpetuity.

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 Example: Growing Perpetuities

Time 0 1 2 3 ... Forever

Cash Flows $3k $3k(1.02) $3k(1.02)
2
... ...

▶ Instead of calculating the PV with long calculations, we can use

the far simpler short cut:

CF1 $3, 000

PV = =
r−g 10% − 2%
= $37, 500

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 4. Growing Annuities
▶ A Growing annuity is a financial Asset that gives the right to
receive a cash flow growing at a rate equal to g for N periods.
Time 0 1 2 ... T T +1
T −1
Cash Flows 0 C C × (1 + g) ... C × (1 + g) 0

C C × (1 + g) C × (1 + g)T −1
PV = + + · · · +
(1 + r) (1 + r)2 (1 + r)T
T
X C(1 + g)n−1
=
(1 + r)n
n=1
 T !
C 1+g
= × 1−
r−g 1+r
 T 
C 
Shortcut: PV = × 1 − 1+g
1+r
r−g
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 4. Growing Annuities: derivation

Time 0 1 2 3 ... T T +1
2 T −1
Cash Flows 0 C C × (1 + g) C × (1 + g) ... C × (1 + g) 0

Formula can be derived from differencing two growing

perpetuities.

C C(1 + g)T 1
=⇒ P V0 = −
r−g r − g (1 + r)T
(1 + g)T
 
C
= 1−
r−g (1 + r)T
(1 + g)T
 
C
= 1−
r−g (1 + r)T

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 Formula Summary
Special formulas for PV of perpetuities and annuities:
▶ CF is the first cashflow at the end of year (period) 1

▶ g (where appropriate) is the growth rate in cashflows as of year

(period) 2

▶ Annual (per period) discount rate of r

The formula for the growing annuity encompasses all of the other
formulas in this section
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 Prices and Yields/Interest Rates

▶ What is the relationship between prices and interet rates?

▶ Perpetuities: P V = C
r
 1

1−
(1+r)T
▶ Annuities: P V = C r

▶ How about more complicated bonds? Depends on the duration

which we’ll turn to later in the class.

▶ How about stocks?

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Returns and Compounding

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 Calculating Returns

▶ Various ways of compounding and quoting interest rates.

▶ Holding Period Returns.

▶ Multiple period returns.

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 Quoted Rates and Compounding

▶ When we have discounted thus far, we have used compound

interest. Common rates that are compound interest:
▶ Discount rate; rate of return; required return; opportunity cost of
capital

▶ Most quoted rates for financial instruments are Annual

Percentage Rates (APR). These rates indicate the amount of
interest earned without the effect of compounding
▶ Credit Cards (12% compounded monthly)

▶ CD rates (5% with daily compounding)

▶ Coupon rates on bonds (10% with semiannual compounding)

▶ Note: we cannot use the APR itself as a discount rate

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 Compounding

▶ Given that APR ignore compounding

=⇒ we cannot use the APR itself as a discount rate
=⇒ it cannot be used for PV or FV

▶ Must translate a stated rate (e.g., APR) into a compound interest

rate! A compound interest rate at the annual horizon is often
called an Effective Annual Rate (EAR) .

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 How do we know if we have an APR?

▶ As noted on the prior slide, if it’s a financial product there’s a

good chance it is an APR.
▶ Look for key tells:
▶ “This CD has an 8% APR with monthly compounding.”

▶ “This credit card charges 12% interest with quarterly

compounding.”

▶ “This semi-annual bond has a yield of 8%.”

▶ In almost all cases, if it’s an APR it will tell you. The only real
exception is bonds, but it’s easy enough to remember that bonds
are quoted in APRs.

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 Translating APR into EAR

▶ A stated rate of 12% with monthly compounding means you pay

1% a month for twelve months!

▶ From the stated rate (APR), the only thing useful is the periodic
rate:

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 Does 12% really mean 12%?

▶ If we deposit $1 today in a bank account that has a stated rate of

12% with monthly compounding, what will we have at the end of
the year?

▶ F V = 1(1.01)12 = $1.1268 =⇒ 12.68% (effective rate)

▶ So what’s the rule?

 rAP R m
rEAR = 1 + −1
m

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10% APR

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 Continuous Compounding

▶ Consider a given quoted rate.

▶ Consider increasingly frequent compounding: annually, quarterly,

daily, minutely, secondly, ...

▶ What happens to the F V ?

▶ Annual quoted rate r with continuous compounding means in t

years:

F V = lim P V × (1 + r/N )N t = P V × ert

N →∞

Also see Handout 3.

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 General Approach

▶ Cash flows define the time line

▶ E.g., if cash flows come every 3-months then timeline is in terms of
3-month ticks

▶ Convert to a discount rate that fits the tick interval of the

timeline
▶ If you are given a compound discount rate, just make sure it fits the
tick interval. E.g., to convert annual compound rate to two-year
rate use 1 + r2 = (1 + r1 )2 .

▶ If you are given a stated rate (e.g., APR), first convert to a

compound rate (e.g., EAR) and then make sure it matches the tick
interval.

▶ Now solve

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 Compounding Example

▶ Suppose annual quoted rate r = 5%, P V = $1000.

▶ Under annual compounding:

▶ 1 year: F V = 1000 × (1 + .05)1 = $1050

▶ 2 years: F V = 1000 × (1 + .05)2 = $1102.50

▶ Under monthly compounding:

▶ 1 year: F V = 1000 × (1 + .05/12)12×1 = $1051.16

▶ 2 year: F V = 1000 × (1 + .05/12)12×2 = $1104.94

▶ Under continuous compounding:

▶ 1 year: F V = 1000 × e.05×1 = $1051.27

▶ 2 years: F V = 1000 × e.05×2 = $1105.17

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 A Couple of Examples

▶ An annual interest rate of 2%, compounded annually, invested for

3 years. $1000 investment.

F V =$1000 × (1 + .02/1)3×1 = $1000 × 1.02 × 1.02 × 1.02

=$1, 061.21

▶ An annual interest rate of 3%, compounded once every quarter,

invested for 2 years. $1000 investment.

F V =$1000 × (1 + .03/4)4×2 = $1000 × 1.00758

=$1, 061.60

▶ Every quarter the investment grows by (1 + .03/4). There are eight

such quarters in two years, hence we take (1 + .03/4) to the power
of 8.

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 A Couple of Examples

▶ A semi-annual interest rate of 3%, compounded every six months.

$1000 investment lasts for 24 months. There are 24/6=4 six month
periods in 24 months. Therefore

F V =$1000 × (1 + .03)4 = $1000 × 1.034

=$1, 125.51

▶ A monthly interest rate of 2%, compounded monthly. $1000

investment lasts for three years.

F V =$1000 × (1 + .02)36 = $2, 039.89

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 Effective Annual Rate
▶ The Effective Annual Rate (EAR) is the annually
compounded rate of return that would result in the same
future value than the quoted rate compounded at the
specified frequency.

▶ Suppose the quoted rate is compounded m times a year.

quoted rate m
 
P V × (1 + EAR) =P V × 1 +
m
quoted rate m
 
=⇒ EAR = 1 + −1
m
▶ The same quoted rate results in a different future value under the
different compounding.

▶ quoted rate
m is called the periodic rate.
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 EAR Calculation:

▶ Let’s calculate the EAR for a number of compounding frequencies.

▶ The annual interest rate is r=12%.

▶ Let’s see the EAR for compounding frequencies of 1 year, 6

months, 1 month, 365 days.

PV r N r/N Years FV F V /P V EAR

1000 12% 1 12% 1 1,120.00 1.1200 12.000%
1000 12% 2 6% 1 1,123.60 1.1236 12.360%
1000 12% 12 1% 1 1,126.83 1.1268 12.683%
1000 12% 365 0.032877% 1 1,127.47 1.1275 12.747%

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 APR: Annual Percentage Rate
▶ By law, lenders are required to report the Annual
Percentage Rate, or APR.

APR = (Interest per Period) × (Number of periods in year)

▶ Q: Suppose that you are American Express, and you want to earn
an effective rate of 18% per year on your credit card business, what
monthly APR do you quote?

0.18 =EAR = (1 + AP R/12)12 − 1

=> AP R =[(1 + EAR)1/12 − 1] × 12 =
=[(1 + 0.18)1/12 − 1] × 12 = 0.1667 = 16.67%

▶ In many settings the quoted rate and the APR are the same.
Sometimes APR accounts for other costs of borrowing.
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 Holding Period Return—HPR
▶ We are now in position to define the most important
concept for measuring the performance of securities—the
Holding Period Return.

▶ Consider any asset (stock, bond, derivative,...). Let Pt denote the

price in period t, and Dt the cash-flow (dividend) in period t.
Denote the value of the portfolio at time t by Vt .

▶ The HPR from time t to t + 1 is defined as:

Vt+1 Pt+1 + Dt+1
HPR = −1= −1
Vt Pt
Pt+1 − Pt + Dt+1
=
Pt
▶ The HPR reflects the performance of an investment,
reflecting both the change in the resale value, as well as
any cash-flows.
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 HPR
▶ We’ll study HPR by working through an example.

▶ Consider a stock of GameStock Inc. that pays a dividend of $2

every six months. Note the price is given after the dividend has
been paid (ex-dividend price).
t Date Price Divid. HPR
0 2017/7 200
.5 2018/1 220 2 0.1100
1 2018/7 220 2 0.0091
1.5 2019/1 219 2 0.0045
2 2019/7 225 2 0.0365
2.5 2020/1 230 2 0.0311
3 2020/7 195 2 -0.1435
▶ For instance, the semi-annual HPR from July 2017 to January
2018 is:
220 + 2
HPR = − 1 = .11 = 11%
200
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 Applying the HPR
▶ Suppose an investor invested $1,000 in GameStock Inc. on 2017/7.

▶ Denote the value of the portfolio at time t by Vt .

▶ What is the portfolio value in 2018/1, at t = .5?

▶ Just multiply the amount invested with the corresponding

HPR:

▶
=⇒ V.5 = (1 + HP R)V0 = (1 + .11) × 1000 = 1110

▶ Equivalent way of defining the HPR:

V.5
= (1 + HP R)
V0

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 Multiple-Period Returns
▶ Suppose at 2018/1 the investor reinvests the dividend
back into GameStock Inc.

▶ How much do they now have invested in the stock?

V1/2 = V0 × (1 + HP R) = 1, 000 × 1.11 = 1, 110

▶ The value of the entire portfolio on 2018/7 will be:

V1 = (1 + .0091) × 1110 = 1, 120.09

▶ Suppose the investor keeps reinvesting all interim dividend

payments in the stock.

▶ How much is the portfolio worth in each of the future

periods?

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 Multi-period Investment

▶ Proceeding in this way allows us to track the performance

of an investment with interim cash-flows reinvested.
t Date Price Divid. HPR Vt
0 2017/7 200 1,000.00
.5 2018/1 220 2 0.1100 1,110.00
1 2018/7 220 2 0.0091 1,120.09
1.5 2019/1 219 2 0.0045 1,125.18
2 2019/7 225 2 0.0365 1,166.28
2.5 2020/1 230 2 0.0311 1,202.57
3 2020/7 195 2 -0.1435 1,030.03

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 Annualizing the HPR
▶ In the previous table we calculated the semi-annual HPR, because
the dividends were paid every 6 months.

▶ Often, we want to express the performance of an investment over a

common time period.

▶ Let T measure the length of the holding period in years, and V0

the initial value of an investment, and VT the ending value.

▶ The annualized holding period return (HPRA ) is defined

as the value that solves:
V0 (1 + HP RA )T = VT
▶ Rearrange to get:
 1
VT T
=⇒ HP RA = −1
V0
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 Annualizing HPR
▶ Let’s add the annualized HPR to the prior table. The six-month
HPR in the first period solves:

V1/2 = V0 (1 + HP R)

▶ Find HPRA such that:

V1/2 = V0 (1 + HP RA )1/2

t Date Price Divid. HPR HPRA Vt

0 2017/7 200 1,000.00
.5 2018/1 220 2 0.1100 0.2321 1,110.00
1 2018/7 220 2 0.0091 0.0183 1,120.09
1.5 2019/1 219 2 0.0045 0.0091 1,125.18
2 2019/7 225 2 0.0365 0.0744 1,166.28
2.5 2020/1 230 2 0.0311 0.0632 1,202.57
3 2020/7 195 2 -0.1435 -0.2664 1,030.03
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 Multiple-Period Returns

▶ Assume an investor reinvested all the dividends, like above.

▶ What is the HPR for the entire period?

V3 V3 V2.5 V2 V1.5 V1 V.5

HP R0,3 + 1 = =
V0 V2.5 V2 V1.5 V1 V.5 V0
▶ But note each of the fractions is a 6-month HPR+1. Therefore the
multi-period HPR is equal to the product of single-period HPRs:

V3
= HP R0,3 + 1 = (1 + HP R3 )(1 + HP R2.5 )...(1 + HP R.5 )
V0
▶ Multiplying the HPRs allows us to calculate the
perfomance of the portfolio with dividends reinvested

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 Multiple-Period Returns
▶ What is the annualized HPR for the entire period?

▶ Recall the definition:

 1/3
V3
HP RA = −1
V0

▶ And now substitute in the expression from previous slide for V3

V0 .

0,3
HP RA = [(1 + HP R.5 )(1 + HP R1 )...(1 + HP R3 )]1/3 − 1

▶ Alternatively, we can calculate the geometric mean of HPRA for

each period:
0,3 1/6
= (1 + HP R.5 )2 (1 + HP R1 )2 ...(1 + HP R3 )2

HP RA −1

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 Multiple-Period Returns

▶ What is the annualized HPR for the entire period?

▶ Let’s calculate the annualized HPR for GameStock Inc using the
entire data:

0,3
HP RA = [(1 + .11)(1 + .0091)(1 + .0045)(1 + .0365)
(1 + .0311)(1 − .1435)]1/3 − 1 = .00991 = .991%

▶ This quantity summarizes the performance of this

investment over time.

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 Multiple-Period Returns, General Case

▶ The formula for T periods is simply:

▶
VT VT VT −1 VT −2 V2 V1
HP R0,T + 1 = = ...
V0 VT −1 VT −2 VT −3 V1 V0
▶ And the formula for annualized HPR is:

0,T
HP RA = [(1 + HP R1 )(1 + HP R2 )...(1 + HP RT )]1/T − 1

▶ The annualized HPR allows us to compare the

performance of different investments with interim
cash-flows.

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 Multiple-Period Returns

▶ We have calculated the six-month HPRs of GameStock

Inc.

▶ You want to know what is the expected value of the HPR for the
next six months. In other words, what is the HPR in an average
period?

▶ The answer is given by the arithmetic average of the individual

six-month HPRs.

▶ For GameStock, the calculation results in:

1
E[HP R] = (.11 + .0091 + ... − .1435) = .00797 = .797%
6

Also see Handout 5.

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Multiple-Period Realized Return, Example

▶ An emerging markets fund had a 100% holding period return in

year 1 and -50% holding period return in year 2.

▶ What is your forecast of next year’s return?

▶ Given by the arithmetic average: 1
2 (100% − 50%) = 25%.

▶ What is the two-year holding period return on this

investment, assuming all proceeds were reinvested?
▶ $100 invested grows to $100 × (1 + 1.0)(1 − 0.5) = $100.

▶ What is the Annualized HPR? Annualized HPR is

(100/100)1/2 − 1 = 0%

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 HPR: Zero-Coupon Bond Example

▶ Consider a zero coupon bond with F V = $1000, P V = $435,

T = 10 years.
▶ What is the yield of this zero-coupon bond?
▶ See next slide.

▶ What is the annualized HPR if you sell the bond early?

▶ after 1 year for $472.758?

▶ after 1 year for $480?

▶ after 1 year for $460?

▶ But didn’t I say zeros are a safe asset? What must have
happened to yields in those three scenarios?
Also see Handout 4.
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 HPR: Zero-Coupon Bond Example
▶ What is the yield of this zero-coupon bond?
1000 1/10
 
r= − 1 = 8.68%
435
▶ What is the annualized HPR if you sell the bond early?

▶ after 1 year for $472.758?

472.758 + 0
HP R = − 1 = 8.68%
435
▶ after 1 year for $480?
480 + 0
HP R = − 1 = 10.345%
435
▶ after 1 year for $460?
460 + 0
HP R = − 1 = 5.747%
435
▶ In first case rates stayed same, in second case rates dropped, in last
case rates increased.
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 Internal Rate of Return aka the Yield

▶ Internal rate of return is a number, denoted IRR, that

solves the equation:
∞
X Ct
PV =
(1 + IRR)t
t=0

▶ “Dollar-weighted” average return.

▶ Return if one can re-invest cash-flows at this rate.

▶ In the context of a bond, the IRR is called the yield.

▶ Is the IRR unique for a given sequence of cash-flows?

Also see Handout 6.

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 Bond Yield
▶ Consider the following two-year, 5% coupon-bearing bond with a
$1000 face value. The one-year interest rate is 2%, and the
two-year interest rate is 4%.
−P V 50 1050
t=0 t=1 t=2

▶ What is the present value of this bond?

50 1050
PV = + = 1019.80
1.02 1.042
▶ What is the yield of this bond? Use Excel or financial
calculator to find y = 3.951%

▶ Double check:
50 1050
+ = 1019.80
1.03951 1.039512
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 IRR example: Project valuation
▶ A firm wants to compute IRR on potential project. Business plan
projects following cash-flows:
▶ Initial investment of machine: $100K

▶ Sales in year 1: $50K

▶ Sales in year 2: $50K

▶ Sales in year 3: $30K, machine is depreciated

−100k 50k 50k 30k
t=0 t=1 t=2 t=3

▶ Solve:

50 50 30
−100 + + + =0
(1 + IRR)1 (1 + IRR)2 (1 + IRR)3
▶ Answer with financial calculator: IRR=15.655%
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 Understanding the Yield
▶ The present value of cash flows C1 , C2 , ..., CT :

C1 C2 C3 CT
PV = + + + ... +
(1 + r1 )1 (1 + r2 )2 (1 + r3 )3 (1 + rT )T
▶ The yield y is the number so that the following equation holds:

C1 C2 C3 CT
PV = 1
+ 2
+ 3
+ ... +
(1 + y) (1 + y) (1 + y) (1 + y)T
▶ Note the Future Value of same cash-flow stream, assuming we
reinvest all cash-flows at the rate y:

F VT = C1 (1 + y)T −1 + C2 (1 + y)T −2 ... + CT

▶ If you could reinvest all the interim cash-flows at the rate

y, they would grow exactly to F V = P V × (1 + y)T .

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 IRR and HPR

▶ You bought 1 Coca Cola share exactly two years ago for $39.63,
earned dividend of $1.12 at end of each year. The combined value
of the share plus the dividend that was paid today is $45.42.

▶ What was the IRR of this investment?

▶ What was your annualized HPR, assuming you

re-invested the first dividend at the IRR?

▶ What was your annualized HPR, assuming you re-invest

first dividend at 5% (the risk-free interest rate)?

For Solution See Handout 7.

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 Recap

▶ Present and Future Value.

▶ Special bonds: perpetuities, annuities.

▶ Quoting interest rates. Compounding frequency and reporting

basis.

▶ EAR and APR.

▶ Holding Period Return. Calculating multiperiod HPR

and expected returns.

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