Chapter 07 - Yield Rates

Section 7.2 - Discounted Cash Flow Analysis

Suppose an investor makes regular withdrawals and deposits into an
investment project. Let Rt denote the return at time t = 0, 1, · · · , n.
We assume that the times are evenly spaced. If
Rt > 0 then it represents a cash withdrawal to the investor from the
project
and if Rt < 0 it is a negative withdrawal, i.e. a deposit from the
investor into the project.
Rt = 0 is possible.
[We could equivalently describe the situation in terms of Ct = −Rt ,
where Ct > 0 is a deposit and Ct < 0 is a withdrawal.]

7-1
Example 1

Investments Returns Net

Period into project from project Cash Flow
0 25,000 0 -25,000
1 10,000 0 -10,000
2 0 2,000 2,000
3 1,000 6,000 5,000
4 0 10,000 10,000
5 0 30,000 30,000
Total 36,000 48,000 12,000

To evaluate the investment project we find the net present value of

the returns, i.e.

7-2
 n
X
NPV = P(i) = ν t Rt
t=0

which can be positive or negative depending on the interest rate i.

Example 1 from page:

i = .02 P(i) = $8, 240.41

i = .06 P(i) = $1, 882.09
i = .10 P(i) = −$3, 223.67
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The yield rate (also called the internal rate of return (IRR)) is the
interest rate i that makes

i.e. this interest rate makes the present value of investments

(deposits) equal to the present value of returns (withdrawals).
7-3
The solution for this interest rate, i, is the process of finding the
appropriate root of a n-degree polynomial. This can be found
iteratively using the Newton-Raphson method. It begins with a rough
approximation ν0 and iterates through

until iterations produce insignificant changes. Here

n
X
f (ν) = ν t Rt and
t=0
n
X
f 0 (ν) = tν t−1 Rt
t=1
Example 1 from three pages earlier:

1
Use i0 = .075 and thus ν0 = 1.075 and it follows that

1 −.162093
ν1 = 1.075 − 151.2194 = .931304

and thus i1 = .073763. Continuing the iteration produces

.000285
ν2 = .931304 − 151.88339 = .931302

and thus i2 = .073765.

We see that the iterative process has basically converged on
i = .0738.

7-5
If R1 = R2 = · · · = Rn ≡ R, then

P(i) = R0 + Ran|i .

The IRR is found by setting P(i) = 0 which produces

which can be solved for i with a financial calculator in the manner

used in chapter 03.

7-6
Exercise 7-3:

The internal rate of return for an investment in which C0 = $3000,

C1 = $1000, R1 = $2000 and R2 = $4000 can be expressed as n1 .
Find n.
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7-7
Section 7.3 - Uniqueness of the Yield Rate
The solution for the yield rate identifies the ν-values that solve
n
X
ν t Rt = 0
t=0

which is a degree n polynomial in ν. Descarte’s Rule of Signs says

that the number of positive real roots of this equation is at most
equal to the number of sign changes in R0 , R1 , · · · , Rn . So as long
as this string changes sign one time there is only one solution for ν
and hence only one appropriate yield rate i.
Example 1 from previous section:
Here R0 = −25000, R1 = −10000, R2 = 2000, R3 = 5000,
R4 = 10000, and R0 = 30000. One sign change means that our
previous solution i = .0738 is unique.

7-8
Example:
Payments of $500 now and $550 two years from now are equivalent
to a payment of $1049 one year from now under what interest rate?
-----------
The equation of value is

The roots of this equation are

p
1049 ± (−1049)2 − 4(500)(550)
ν=
2(550)
1049 ± 20.05
=
1100
. .
ν1 = .97184 ν2 = .9354318
. .
i1 = .028975 i2 = .069025
Which root is the more appropriate?

7-9
Exercise 7-5:
Project P requires an investment of $4000 at time 0. The investment
pays $2000 at time 1 and $4000 at time 2. Project Q requires an
investment of $x at time 2. The investment pays $2000 at time 0 and
$4000 at time 1. Using the net present value method at an effective
interest rate of 10%, the net present value of the two projects are
equal. Calculate x.
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7-10
Exercise 7-8:

Payments of $100 now and $108.15 two years from now are
equivalent to a payment of $208 one year from now at either rate i or
j. Find the absolute difference between the two rates.
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7-11
Section 7.4 - Reinvestment Rates
Suppose the situation is such that payments received cannot be
reinvested at an interest rate that is equal to that of the original
investment project. For example, suppose 1 is invested in an
account which pays i per period for each of n periods and then
returns the principal of 1 at time t = n. Suppose also that the
interest earned is reinvested at rate j.
1
Payment

0 1 2 ... n−1 n

Time 7-12
The accumulated value at time t = n is:

i
= 1 + isn|j = 1 + ((1 + j)n − 1)
j
Note that when j = i, this formula becomes the usual compound
interest formula :
(1 + i)n , but often j is less than i.

Now suppose 1 is invested at the end of each of the n periods. Each

deposit earns interest at rate i, but all interest earned is reinvested at
rate j. Then the accumulated value at time t = n is:
(1 + isn−1|j ) + (1 + isn−2|j ) + · · · + (1 + is1|j ) + 1
n−1
X
=n+i sn−t|j
t=1
7-13
 n−1
X ((1 + j)t − 1)
=n+i
j
t=1

i (1 + j)[(1 + j)n−1 − 1]
=n+
j
( (1 + j) − 1
− (n − 1)) SGS

i (1 + j)n − 1 − j
=n+
j
( j
− (n − 1))

Example
A $1000 bond with 5% coupon rate payable semiannually is
redeemable in 5 years at face value. The price is set so that the
investor expects a 6% yield convertible semiannually, but the
payments can only be reinvested at 4% convertible semiannually.
What is the investor’s actual yield rate from this investment?
7-14
The price of the bond is :

P = C + C(g − i)an|i
= 1000 + 1000(.025 − .03)a10|.03
= 957.35

At t = 10 the $25 coupon payments plus the redemption value

accumulate to

1000 + 25s10|.02

[(1.02)10 − 1]
1000 + 25 = 1273.74.
.02
So the actual semiannual yield i 0 satisfies

The annual effective interest rate is found by

(1 + i) = (1 + .028996)2 or i = .05877
7-15
Exercise 7-12:

A loan of $10,000 is being repaid with payments of $1000 at the end

of each year for 20 years. If each payment is immediately reinvested
at 5% effective, find the effective annual rate of interest earned over
the 20-year period.
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7-16
Section 7.5 - Interest Measurement of a Fund

The purpose of this section is to describe a yield rate for an

investment fund over a single period (typically one year). Let

A = amount in the fund at the beginning of the period

B = amount in the fund a the end of the period

I = amount of interest earned during the period
Ct = net amount contributed to the fund at time t, 0 ≤ t ≤ 1.
Ct > 0 denotes a deposit
Ct < 0 denotes a withdrawal
C = total amount contributed during the period
X
C= Ct
t
It follows from these descriptions that

For the interest to be consistent with a yield rate of i,

X
I = iA + Ct (interest rate from t to 1)
t

where the interest rate from t to 1 is

1−t it = (1 + i)1−t − 1 under compound interest
= i(1 − t) under simple interest

Under compound interest,

X
B = (1 + i)A + Ct (1 + i)1−t or
t
X
A = νB − Ct ν t
t
which requires an iterative process to solve for ν and thus i.
7-18
Under simple interest,
X
I = iA + Ct i(1 − t) or
t

P
Here the denominator A + t Ct (1 − t) is called the exposure
associated with i. A simple approximation to this i can be obtained
by assuming all contributions occurred at time t = 1/2, in which case
I
i =
A + .5C
2I
=
A+B−I

7-19
Example:
A fund begins the year with a balance of $1000. A deposit of $500 is
made at the end of the first quarter and a withdrawal of $200 is
made at the end of the 2nd and 3rd quarters. What is the yield if the
fund finishes the year with a balance of $1220? Use simple interest.

A = 1000 B = 1220 C = 100.

Note that I = 120 and

X
Ct (1 − t) = 500(3/4) + (−200)(1/2) + (−200)(1/4) = 225.
t

It follows that

7-20
The yield computation method described above is said to be dollar
weighted, because the dollar contributions (or withdrawals) of the
investor play a major role in determining the yield. Consider the
previous example , but with C1 = −400, C2 = 0, and C3 = 500 at the
ends of the 1st, 2nd and 3rd quarters, respectively. Use A and B as
the same as above and note that C and I are also the same. But
X
Ct (1 − t) = −400(3/4) + 500(1/4) = −175.
t

and therefore
120
i= = .14545.
1000 − 175
Thus yield is highly dependent on the timing and contribution
amounts of the investor.

7-21
Exercise 7-20:
An investment account earning 6% is established with an balance at
the beginning of the year of $10,000. There are new deposits of
$1800 made at the end of two months and another $900 made at the
end of eight months. In addition, there is a withdrawal of $k made at
the end of six months. The fund balance at the end of the year is
$10,636. Determine k to the nearest dollar using simple interest.
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7-22
Section 7.6 - Time Weighted Rates of Interest

When assessing the performance of an investor, dollar weighting is

quite appropriate. But when assessing the performance of the fund
itself and/or the fund administrators, this strong dependence on the
timing and contribution amounts of the investor is less appropriate.

Suppose contributions are made at times tk for k = 1, 2, · · · , m − 1

at times t0 ≡ 0 < t1 < t2 < · · · < tm−1 < tm ≡ 1. Let

Bk0 = the fund balance just before the contribution at time tk

Ck0 = the contribution amount made at time tk

Ck0 > 0 indicating a deposit and Ck0 < 0, a withdrawal.

7-23
The interest rate, jk , achieved during the time period (tk −1 , tk )
satisfies

(Bk0 −1 + Ck0 −1 )(1 + jk ) = Bk0 or

Bk0
(1 + jk ) =
Bk0 −1 + Ck0 −1
where we recognize that (1 + jk ) can be greater than or less than 1.
The accumulated value over (0, 1), set equal to (1 + i) produces

The value i which satisfies this equation is the time-weighted yield of

the fund and is more reflective of the performance of the fund itself
and less dependent on the timing and contribution amounts of the
investor.

7-24
Example (continuation from section 7.5)
Earlier we found the dollar weighted yield to be i = .09796. We will
now compute the time-weighted yield. For this we need additional
information, namely the values of B10 =$1020, B20 =$1555, and
B30 =$1482. Those values and the ingredients of the computations
are shown in the table below.

k Bk0 Ck0 (1 + jk )
0 0 1000
1 1020 500 1.0200
2 1555 -200 1.0230
3 1482 -200 1.0937
4 1220 0 0.9516

Here, for example,

1555
(1 + j2 ) = = 1.0230
1020 + 500

7-25
and
1220
(1 + j4 ) = = 0.9516.
1482 − 200
To compute the yield we form:

Therefore, the time weighted yield is

i = .0860

7-26
Exercise 7-26:
You invest $2000 at time t = 0 and an additional $1000 at time
t = 1/2. At time t = 1 you have $3200 in your account. Find the
amount that would have to be in your account at time t = 1/2, if the
time weighted rate of return over the year is exactly .02 higher than
the dollar weighted rate of return. Assume simple interest in
calculating the dollar weighted return.
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7-27
Exercise 7-28:
An investor deposits 50 in an investment account on January 1. The
following summarizes the activity in the account during the year:
Date Value just before deposit Deposit
March 15 40 20
June 1 80 80
October 1 175 75
On June 30 the value of the account is $157.50. On December 31
the value of the account is x. Using the time weighted method, the
equivalent annual yield during the first 6 months is equal to the
time-weighted annual yield during the entire one year period.
Calculate x.
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7-28
Section 7.7 Portfolio Method
An investment fund is typically created to serve a number of
individual persons or companies. When it comes to crediting interest
to the individual accounts, the fund can do this in one of several
ways.
Many funds are set up so that deposits to the fund buy shares in the
fund. Interest from the fund’s performance for a given year is
distributed to individual accounts in proportion to the number of
shares held in the account during that year. This is called the
portfolio method of assigning a yield for the individual accounts. With
this method, the same interest rate is applied to the total amount
accrued in each account in a particular year. This is a allocation
method that is relatively simple to perform and to explain to fund
members.
Some funds use a more complicated method designed to attract
new money into the fund during times of rising interest (improving
fund performance). One such method is called the investment year
method. This method is described in our textbook, but we will not
describe it here because it has been dropped from the FM exam. 7-29