Real Rate of Return

3 Key excerpts on "Real Rate of Return"

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  eBook - ePub

  Financial Mathematics for Actuaries

  • Wai-Sum Chan, Yiu-Kuen Tse;;;(Authors)
  • 2017(Publication Date)
  • WSPC

    (Publisher)

  4

  Rates of Return

  The performance of investment projects, funds and portfolios of assets is typically measured by their rates of return. The most important measure of the return of a project or fund is the internal rate of return, also called the yield rate. In this chapter we define the internal rate of return and explain how it can be applied to various investment projects. We discuss measures of 1-period rate of return, including methods such as the dollar-weighted rate of return, time-weighted rate of return, as well as some approximation methods. Performance of funds over an extended period of time can be measured by the geometric mean rate of return and arithmetic mean rate of return. We also show how returns of a portfolio can be calculated from the returns of its component assets.

  Short selling is a strategy through which investors can leverage. We consider the computation of the rate of return of a short-selling strategy. We also discuss methods of crediting interests in a fund, including the investment-year method and the portfolio method. Finally, we discuss methods of project appraisal, namely, the criteria of deciding whether or not to invest in a project.

  Learning Objectives

  • Internal rate of return (yield rate)

  • 1-period rate of return of a fund: time-weighted rate of return and dollar-weighted (money-weighted) rate of return

  • Rate of return over longer periods: geometric mean rate of return and arithmetic mean rate of return

  • Portfolio return

  • Return of a short-selling strategy

  • Crediting interest: investment-year method and portfolio method

  • Capital budgeting and project appraisal

  4.1 Internal Rate of Return

  Consider a project with initial investment C0 to generate a stream of future cash flows. For simplicity, we assume the cash flows occur at regular intervals, say, annually. The project lasts for n years and the future cash flows are denoted by C1 ,···, Cn . We adopt the convention that cash inflows to the project (investments) are positive and cash outflows from the project (withdrawals) are negative. We define the internal rate of return (IRR) (also called the yield rate) as the rate of interest such that the sum of the present values of the cash flows is equated to zero. Denoting the internal rate of return by y

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  eBook - ePub

  Terms of Trade

  Glossary of International Economics

  • Alan V Deardorff(Author)
  • 2014(Publication Date)
  • WSPC

    (Publisher)

  page 362 ).

  Real effective exchange rate

  The effective exchange rate (page 126 ) adjusted for the rates of inflation (page 221 ) in each country.

  Real exchange rate

  1. The nominal exchange rate (page 308 ) adjusted for inflation. Unlike most other real (page 363 ) variables, this adjustment requires accounting for price levels in two currencies. The real exchange rate is: R = EP* /P where E is the nominal domestic-currency price of foreign currency, P is the domestic price level, and P* is the foreign price level.

  2. The real price of foreign goods; i.e., the quantity of domestic goods needed to purchase a unit of foreign goods. Equals the reciprocal of the terms of trade (page 429 ). Equivalent to definition 1.

  3. The relative price of traded goods (page 445 ) in terms of nontraded goods (page 312 ).

  Real GDP

  The real counterpart to nominal GDP (page 308 ), obtained by valuing output in a given year at prices from another year, called the base year (page 28 ).

  Real interest rate

  The nominal interest rate adjusted for inflation (page 221 ), to get the percentage yield an asset holder receives in terms of real resources. Equals the nominal interest rate minus the rate of inflation.

  Real model

  An economic model without money. Most general equilibrium (page 184 ) models of trade are real models. This includes the Ricardian model (page 378 ), the Heckscher-Ohlin Model (page 199 ), and the models of the new trade theory (page 306 ).

  Real money balances

  The real (page 363 ) value of the amount of money (page 287 ) held by a person, household, or firm, or the amount in circulation in the economy.

  Real national income

  National income (page 297 ) adjusted for inflation (page 6 ).

  Real terms

  Same as real (page 363

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  eBook - ePub

  Discounting for Time and Risk in Energy Policy

  • Robert C. Lind, Kenneth J. Arrow, Gordon R. Corey, Partha Dasgupta, Amartya K. Sen, Thomas Stauffer, Joseph E. Stiglitz, J.A. Stockfisch(Authors)
  • 2013(Publication Date)
  • RFF Press

    (Publisher)

  If there is a difference between the two rates, a method must be worked out for dealing with the problem of possible misallocation of resources. Marglin (1963) and Feldstein (1964) have presented two such methods, both of which require information about the rate of return in the private sector. In other words, to employ a social discount rate as a feature of the government’s resource-allocation apparatus requires information about the profitability of private investment that will be displaced or stimulated by the government’s investment behavior. This is the second reason that a measure of the prevailing private sector rate of return is relevant to discussion of the social rate of discount.

  However, the idea of “the” rate of return on private investment is itself an abstraction. The concept follows from equilibrium theory, in which rates of return obtainable from investment in many activities are equalized. Of course, during any given period for which empirical measures are taken, such equality will not be found. This condition is inherent in real economies in which preferences, technology, and other conditions change. Moreover, taxes—particularly property and corporation profits taxes—drive a wedge between physical asset earnings and the yields of private ownership claims. Rate-of-return measures thus will be biased downward. These same measures, even when adjusted for taxes, may still have shortcomings. Financial information, at best, may provide insight only into average rates of return. Yet it is the marginal rate of return that is relevant to resource allocation. Thus, the question arises whether and the extent to which some sort of average rate can serve as a measure of its marginal counterpart. To address this question requires a theoretical model.

  The Theory of the Rate of Return on Private Investment: A Neoclassical Static Model The Model

  By social rate of return on private investment, I mean a measure of such concepts as “the marginal productivity of capital,” “the marginal efficiency of investment,” “the marginal rate of return over cost,” and so on. These concepts are adjuncts of capital theory and, as such, are both ambiguous and controversial. This condition requires that any particular version of the rate of return be specified carefully. This section attempts to lay the comparative static foundation of capital theory.

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