Question

Define and describe the following: 1. Capital Gain/Loss 2. Current Yield (be sure to review the Module Notes) 3. Holding Period Return (be sure to review the Module Notes) 4. Investment Horizon.

Answer 1

Solution:

1. Capital gain/loss refers to the profit/loss earned when an asset is sold. Generally, these assets include bonds, stocks, real estate, etc. It arises due to the difference between the purchase price of an asset and its selling price. When the selling price of an asset is higher than the price at which it was purchased initially, it results in capital gain. When the selling price of an asset is lower than the price at which it was purchased initially, it results in capital loss. Capital gain can be a short term or long term gain.

2. Current is also called Basic Yield. It relates the coupon interest rate with the current market price of the bond. Current yield changes with the change in market price of the bod. It is calculated as a ratio of coupon rate to the market price:

Current Yield = Interest/B₀*100

Here, Interest = Annual Interest Income

B₀  = Current Market Price of Bond

Current yield exceeds the coupon rate when the bond is selling at discount (price lower than the Face Value) and it is lower than the coupon rate when the bond is selling at a premium (price higher than the face value). When market price is equal to the face value of the bond, the current yield and coupon rate are the same.

Limitations of the current yield:

(i) It ignores the prospective capital gain or loss which may occur in future.

(ii) It ignores the idea of reinvestment of interest income for the remaining life of the bond.

3. Holding period return (HPR) equals the income earned (including capital gains or losses) over a period as a percentage of the bond price at the start of the period. In the context of holding periods return, the holding period refers to the length of time over which an investor is assumed to hold an investment. HPR is calculated as :

HPR = {Total Interest Income + (B_s - B₀)}/B₀*100

Here, B_s= Sale price of the bond at the end of the holding period

B₀ = Market price of the bond at the starting of the holding period

4. Investment horizon refers to the period from the date of purchase of an investment to its planned liquidation date. It can be a short-term or long-term period. Investment horizon must be considered by investors while choosing and selecting investments. Investment horizon depends upon the factors like risk-taking capacity of an investor and income needs of an investor.