Many investments pay periodic income; that is, they make more than one payment throughout the year. This makes it difficult to compare the rate of return on similar investments. One solution is to calculate the annualised percentage rate and yield (compounding) which turns the periodic rate into an annual rate.
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- Calculator or spreadsheet
Determine the periodic rate of the financial instrument. This is the rate paid per period. Let's say you own a certificate of deposit (CD) that pays 1.05 per cent interest at the end of every month.
Figure out the number of periods a payment is made throughout the year. If a security pays semi-annual, as most bonds do, there are two payment periods, however, if the security pays out every month, there are 12 payment periods in the year.
Calculate the annualzed percentage rate without compounding (calculating the interst on the interest). Muliplty the periodic rate by the number of periods. For example, the calculation is: 1.05 per cent x 12 = 12.6 per cent.
Calculate the annualised percentage rate with compounding. Add 1 to the period rate. Take the sum to the exponent x, where x is the number of payments made in the year and then subtract 1. The calculation is: .0105 + 1 = 1.0105^12 = 1.133537297 - 1 = .133 or 13.3 per cent which is slightly higher than calculating the annualised without compounding.
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