Holding Period Yield or Comparative yield
When investing in domestic assets, investors look at the yield of the asset. The yield of an asset can easily be calculated depending on the asset price and maturity. So for example in the case of a T-Bill whoâ€™s price is $98 with a face value of $100 maturing 90 days from now the yield can be computed by
yield = 100-98/100 x 360/90 assuming the day count convention for t-bills is actual/360
The yield to maturity for this security is 8%
However the yield to maturity is the yield earned on the security if the security is held to maturity. Many times the security is never held till maturity but liquidated much before the maturity date depending on whether cash is required or profit must be taken or losses booked.
Lets assume that due to liquidity issues the trader needs to square the position. However the interest rates in the economy have increased after 10 days and the profile of a similar T-Bill yields 12%
Based on that yield the price of the purchased T-Bill would now be
12% = (100-P)/100 x 360/80
P = 97.33
The holding period yield is therefore
(the end value/amount invested)^ 1/(t = number of years invested) -1
or simply you can compute it by [(97.33 – 98)/98] /80 * 360 = -0.03 or a negative yield of 3%.
So you see how the holding period yield differs significantly from the yield to maturity.
Next we look at the HPY when investors invest in foreign assets.
Adding exchange rate risk to HPY
In the world of international finance money flows almost freely across countries looking for low risk high yielding assets.
For foreign investors investing in $ assets the HPY of the asset now becomes a function of the HPY of the dollar assets, the exchange rate at the deal inception and the exchange rate at the end of the trade.
If the HPY on the dollar asset is say 5%, however the loss on exchange rate is 3% then the net HPY is roughly 2%
As a close approximation the
HPY on foreign investment = expected dollar yield on asset + expected yield on exchange rate change
Why it is called comparative yield is because in order to decide whether to invest in US assets foreigners will compare the expected yield they are likely to earn on dollar assets to the yield they can earn elsewhere. More favourable the asset yield and the strength of the US dollar the more likely foreigners will invest in the US compared to other countries. A fall in foreign interest rates will also cause a move towards higher yielding US assets.
Next we look at comparative risk.
The second factor that foreign investors consider when investing abroad is comparative risk.
Risk can be lowered through diversification. Hence a foreign investor can diversify risk by investing a portion of funds in domestic assets and the balance in foreign assets. However due to restrictions in capital flows it may not be that easy.
There are other risk factors that play an important part in deciding whether to invest abroad such as – political risk, the countryâ€™s sovereign risk, exchange rate risk etc.