Chapter 05_Hand-out 4

# Chapter 05_Hand-out 4 - CHAPTER 5 RISK AND RATE OF RETURN...

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CHAPTER 5 RISK AND RATE OF RETURN 5.1 INFLATION AND REAL RATES OF RETURN 1. Real vs. Nominal Rates of Interest The distinction between the real and the nominal rate of return is crucial in making investment choices when investors are interested in the future purchasing power of their wealth. Thus a U.S. Treasury bond that offers a "risk-free" nominal rate of return is not truly a risk-free investment - it does not guarantee the future purchasing power of its cash flow. Even professional economic forecasters acknowledge that their inflation forecasts are hardly certain even for the next year, not to mention the next 20. When you look at an asset from the perspective of its future purchasing power, you can see that an asset that is riskless in nominal terms can be very risky in real terms. Forecasting interest rates is one of the most notoriously difficult parts of applied macroeconomics. Nonetheless, we do have a good understanding of the fundamental factors that determine the level of interest rates: 1. The supply of funds from savers, primarily households. 2. The demand for funds from businesses to be used to finance investments in plant, equipment, and inventories (real assets or capital formation). 3. The government's net supply and/or demand for funds as modified by actions of the Federal Reserve Bank. We need to distinguish between a nominal interest rate - the growth rate of your money - and a real interest rate - the growth rate of your purchasing power. If we call R the nominal rate, r the real rate, and i the inflation rate, then we conclude: i - R r In words, the real rate of interest is the nominal rate reduced by the loss of purchasing power resulting from inflation. In fact, the exact relationship between the real and nominal interest rate is given by: i 1 R 1 r 1 + + = + , or i 1 i R r + - = , which shows that the approximation rule overstates the real rate by the factor 1 + i . The approximation rule is more exact for small inflation rates and is perfectly 1

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exact for continuously compounded rates. 2. The Equilibrium Real Rate of Interest Real and nominal rates As we said before three basic factors - supply, demand, and government actions - determine the real interest rate. The nominal interest rate, which is the rate we actually observe, is the real rate plus the expected rate of inflation. So, a fourth factor affecting the interest rate is the expected rate of inflation. If we consider the supply and demand curves for funds, equilibrium is at the point of intersection of the supply and demand curves. The government and the central bank (Federal Reserve) can shift these supply and demand curves either to the right or to the left through fiscal and monetary policies. Thus, although the fundamental determinants of the real interest rate are the propensity of households to save and the expected productivity (or we could say profitability) of investment in physical capital, the real rate can be affected as well by government fiscal and monetary policies. Because the investors should be concerned with their real
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## This note was uploaded on 09/25/2011 for the course FINA 4320 taught by Professor John during the Spring '11 term at Houston Baptist.

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Chapter 05_Hand-out 4 - CHAPTER 5 RISK AND RATE OF RETURN...

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