ANNUALIZING INTEREST RATES

I was looking through week 2s lecture and realized I actually didnt

understand how you annualized the HPR. I know what the formula
is, but why does it work? As in, how was it derived what does each
component mean?
Annualizing holding period returns is no different than annualizing other returns. Lets start by considering simple returns. These measure net changes in
wealth and are not adjusted for the time period over which these changes occur.
For instance, lets assume that we have a flat and constant term structure and
that we buy a three-year annual coupon bond (paying some coupon c) at t = 0,
reinvest all coupons until t = 2 and sell the bond at t = 2. Our cash flows would
be:
CF0 = P
CF2 = c(1 + y) + c + P2 = c(2 + y) +

FV + c
1+y

Our simple return would be:

i
h
V +c
c(2 + y) + F1+y
1
rs =
P
There are a lot of variables there, but all we are doing is calculating how much
our wealth have changed as a result of the investment. This is fine but in order
to compare different returns we need to take the time it took to earn the return
into account. A return of 2 % may be very good over a day, but much less
impressive over 10 years. We often normalize the return, so as to express the
annualized return, i.e. the return we would have made if we had the same rate
of change in our wealth, but kept it up for exactly one year. Lets denote this
annualized rate rA for now. In order to make the comparison fair, we should let
rA work over the same time period as rs , i.e. two years. We then choose rA so
that the change in wealth is equal:
(1 + rA )2 = 1 + rs
1

(1 + rs ) 2 1 = rA
1

This is the equation we had in the lecture slides (although we wrote X 2 as

X). We can make this formula more general by substituting some arbitrary

number of years, T , for 2:

1

rA = (1 + rs ) T 1

Note that the we do not require T to be an integer. If we want to annualize a

three-month return, we would have T =
1

rA = (1 + rs )1/ 4 1
rA = (1 + rs )4 1

1
4

and get: