In this sum of CME Chptr2 , I could not understand if yield is to rise by 2% over 2 years then why in 9th line it is 1% divided by 2. if cumulative yield is risen by 2% then ideally for annual return it should be 2% divided by 2.
Pls explain cumulative return calulation.
We assume that the 2% rise in yield is happening linearly. So, at the end of first year yield rises 1%. So, the cashflows received at the end of the first year are going to be reinvested at a 1% higher rate. At the end of the second year, the yield increases another 1%. The second year cashflows are going to be reinvested at this 1% higher than previous (or 2% higher than original) rate.
While calculating the return for a 2 year horizon, we cannot include the yield rise of 1% at the end of year 2 because no reinvestment benefit is derived from that 1% rise. For horizon greater than 2 years, the reinvestment benefit from that 1% rise is realised so 5 year and 7 year portfolios incorporate that.
Please listen audio for your query.