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**Unformatted text preview: **Funds Supplied/Demanded funds, causing the supply function in Figure 6.1 to shift to, say, S1. This could
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result in a lower real rate of interest, k1 , at equilibrium (S1 D). Likewise, a
change in tax laws or other factors could affect the demand for funds, causing the
real rate of interest to rise or fall to a new equilibrium level. Nominal or Actual Rate of Interest (Return)
nominal rate of interest
The actual rate of interest
charged by the supplier of funds
and paid by the demander. The nominal rate of interest is the actual rate of interest charged by the supplier
of funds and paid by the demander. Throughout this book, interest rates and
required rates of return are nominal rates unless otherwise noted. The nominal
rate of interest differs from the real rate of interest, k*, as a result of two factors:
(1) inflationary expectations reflected in an inflation premium (IP), and (2) issuer
and issue characteristics, such as default risk and contractual provisions, reflected
in a risk premium (RP). When this notation is adopted, the nominal rate of interest for security 1, k1, is given in Equation 6.1:
k1 k* IP RP1 (6.1) risk-free
risk
rate, RF premium As the horizontal braces below the equation indicate, the nominal rate, k1, can be
viewed as having two basic components: a risk-free rate of interest, RF, and a risk
premium, RP1:
k1 RF RP1 (6.2) To simplify the discussion, we will assume that the risk premium, RP1, is
equal to zero. By drawing from Equation 6.1,3 the risk-free rate can (as earlier
noted in Equation 5.9) be represented as
RF k* IP (6.3) 3. This equation is commonly called the Fisher equation, named for the renowned economist Irving Fisher, who first
presented this approximate relationship between nominal interest and the rate of inflation. See Irving Fisher, The
Theory of Interest (New York: Macmillan, 1930). 266 PART 2 Important Financial Concepts Thus we concern ourselves only with the risk-free rate of interest, RF, which was
defined in Chapter 5 as the required return on a risk-free...

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