3 embodies the real rate of interest plus the

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

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

This document was uploaded on 01/19/2014.

Ask a homework question - tutors are online