Chapter 6: Real Interest Rates
What Are Real Interest Rates?
Nominal interest rate: the amount of interest paid on debt principal as % of principal.
Real interest rate: nominal interest rate adjusted for expected inflation.
Expected real interest rate: nominal interest rate adjusted for expected inflation.
Aka. Ex ante real interest rate
expected real interest rate on a bond formula:
R= 1+i/1+g – 1
use this formula when interest rate and exp. Inflation rate are high
Expected real interest rate: nominal interest rate expected inflation rate
use this formula for most calculations
Realized real interest rate: nominal interest rate adjusted for actual inflation. Aka. Ex
post real interest rate
expected real interest rate is more relevant to investors and business firms because
investment decisions are made before anyone knows the actual inflation rate.
when inflation rate is higher, borrower is better off, and lender is worse off and vice
Calculating expected inflation rate:
E=p1x1 + p2x2 + p3x3
P=probability x=expected inflation.
Inflation indexed securities
when you buy them, you are guaranteed a fixed real payment until the security matures
the value of the principal is adjusted every 6 months for inflation
Inflation adjusted principal: original principal x ratio of inflation indexes
Interest pmt: inflation adjusted principal x semi annual interest rate
= 10,000 x 0.06/2
information about inflation indexes is not known immediately
taxed on both real interest income and inflation adjusted principal
Real Present Val