Posted in Finance, Accounting and Economics Terms, Total Reads: 432
Definition: Effective Yield
Effective interest rate or Effective yield is the yield on a financial instrument such as a bond restated from a nominal interest rate based on frequency of compounding and effective over a year. It is usually used to compare the returns an investor gets from investing in differing coupon paying structures such as annual coupon vs semi-annual vs quarterly vs monthly etc.
The effective yield of an instrument is calculated from the following formula:
Where i is the periodic interest rate, n is the frequency of compounding and is the number of period in the year and finally r is the effective yield.
For example, if a $ 100 bond of company A pays 10% coupon semi-annually, then its effective yield is,
r = (1 + (10%/2))^2 – 1 = 10.25%
Whereas, for the same bond in all respects but differing the coupon which is now paid monthly, effective yield comes out to be,
r = (1 + (10%/12))^12 – 1 = 10.47%
Thus we can conclude that the yield on a monthly coupon paying bond is higher than that of semi-annual bond
In case, the frequency of compounding is continuous, then effective yield becomes,
For the same problem, if the coupon is paid based on continuous compounding, the effective yield becomes,
r = e^10% - 1 = 10.51%
Thus as we can see, as the frequency of compounding becomes larger, the effective yield increases.
Effective yield is a more accurate measure of return from an investment as it takes compounding into account. However, it also assumes that the coupons can be reinvested at the same rate again which may not be the case always especially if the interest rates are falling.