Posted by John Behle on December 04, 2002 at 13:31:00:
In Reply to: Different Rates Question posted by Abel on November 21, 2002 at 08:31:25:
Effective and nominal rates refer primarily to other investments and are rarely used in the note industry. That and Thanksgiving are the reasons for the long wait for an answer.
An effective rate of return is the return earned on an investment, including compound interest, assuming the investment remained in a fund for a full calendar year and the underlying portfolio remained the same.
A nominal rate of return is the stated return earned, ignoring compound interest and other factors.
The effective yield on an investment is most pertinent to income and money market funds. It is this yield that can be compared to the interest rates offered on bank deposits.
IRR or Internal Rate of Return is the calculation that is most important in the cash flow industry. For most, this is the same as yield, but in other industries there are different types of yield, so you can’t always assume people are talking the same language when they use the term yield.
Internal Rate of Return calculations take into account compounding and are closer to effective rate. There are flaws or should we say pros and cons to most types of common calculations that are used. The flaw with Internal Rate of Return is it assumes a re-investment rate on the cash flows equal to the yield. In other words, if you have a note you purchased at an 18% yield, the IRR calculation assumes the monthly payments received are then re-invested at 18% - which is rarely the case.
There’s an article I wrote on this site that goes into more details about Internal Rates of Return (IRR) and Financial Management Rates of Return (FMRR). See the “Free Articles” section.