**Unformatted text preview: **asset.4 The risk-free rate
(as shown in Equation 6.3) embodies the real rate of interest plus the inflationary
expectation. Three-month U.S. Treasury bills (T-bills), which are (as noted in
Chapter 5) short-term IOUs issued by the U.S. Treasury, are commonly considered
the risk-free asset. The real rate of interest can be estimated by subtracting the
inflation premium from the nominal rate of interest. For the risk-free asset in Equation 6.3, the real rate of interest, k*, would equal RF IP. A simple example can
demonstrate the practical distinction between nominal and real rates of interest.
EXAMPLE Marilyn Carbo has $10 that she can spend on candy costing $0.25 per piece. She
could therefore buy 40 pieces of candy ($10.00/$0.25) today. The nominal rate
of interest on a 1-year deposit is currently 7%, and the expected rate of inflation
over the coming year is 4%. Instead of buying the 40 pieces of candy today,
Marilyn could invest the $10 in a 1-year deposit account now. At the end of 1
year she would have $10.70 because she would have earned 7% interest—an
additional $0.70 (0.07 $10.00)—on her $10 deposit. The 4% inflation rate
would over the 1-year period increase the cost of the candy by 4%—an additional $0.01 (0.04 $0.25)—to $0.26 per piece. As a result, at the end of the 1year period Marilyn would be able to buy about 41.2 pieces of candy
($10.70/$0.26), or roughly 3% more (41.2/40.0 1.03). The increase in the
amount of money available to Marilyn at the end of 1 year is merely her nominal
rate of return (7%), which must be reduced by the rate of inflation (4%) during
the period to determine her real rate of return of 3%. Marilyn’s increased buying
power therefore equals her 3% real rate of return.
The premium for inflationary expectations in Equation 6.3 represents the
average rate of inflation expected over the life of a loan or investment. It is not
the rate of inflation experienced over the immediate past; rather, it reflects the
forecasted rate. Take, for example, the risk-free asset....

View
Full
Document