Example one is very confusing to me.
Assuming yields rise linearly over 2 years, the higher reinvestment rates will boast the cumulative returns by approximately by 1% over two years, so the annual return over two years will be -1.09= 3.25 (9.68+1.00)/2. Here, my question is that 9.68 already includes 1% rise in rates over two years. Where is this 1% come from and why it is added to 9.68 and divided by two?
Thanks in advance.
-9.68% is the price return - negative as rates have increased
1% is the re-invesment return - positve as rates have increased
In this case, the annual return is YTM adjusted for capital loss and reinvestment return. Capital gain/loss and reinvestment have to be annualized. That’s why it divided by two ( both capital gain/loss and reinvestment are over the two years).
Capital Loss= 4.84*2% (over the two years).
Reinvestment return is 1%, which comes from the increasing global government yields. It says that the global government yields rise by 200bps over the next two years.
Thus the annual return=3.25%+(-9.68%+1%)/2
Ok. so I understand -9.68% capital loss is for two years, so should be divided by 2.
But rates are rising 2% over two years right? so it is 1% over 1 year. Why divide by 2 here?
I agree and think they have double averaged the yield pick up.
If yields rise to 2% over two years that is “on average 1% per annum” and does not need averaging again.
Oh yes, it shouldn’t. I thought that the total increase is 100bps during this period. But actually it should be 100bps*periods. And then the annualized reinvestment return is 100bps. You’re right.
Thanks guys. So what should we do on the exam if similar question comes?
3.5 + 9.68/2 + 1
The techncial checks on exam questions much higher than the rest of their material