Part 2: Real and Nominal Risk-free Rates-Theory In Part 2, we are going to explore the...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
Part 2: Real and Nominal Risk-free Rates-Theory In Part 2, we are going to explore the concept of nominal and real risk-free rates. The nominal risk-free rate tells us how many additional pictures of Geo. Washington we will receive in the future in return for an investment in a risk-free security such as U.S. government bonds. The real risk-free rate tells us how much more physical stuff we will be able to consume in the future in return for an investment in a risk- free security. Since we no longer use the barter system as a means of exchange, most interest rates, including risk-free rates, are quoted in nominal terms. Thus, unless otherwise stated, any risk-free rate is assumed to be a nominal rate. The difference between nominal and real rates is the inflation rate. For instance, in problem 1 above, we were promised $1,040 pictures of Geo. Washington in the future for a $1,000 investment now. This is a nominal rate-we are to receive 40 extra pictures of Washington in exchange for the U.S. government using our money for a year. However, we don't care about pictures of Geo. Washington per se. What we really care about is how much we can buy with the dollars we receive. The real rate tells us how much we will receive in terms of goods and services rather than pictures of Washington. Let's do an exercise to see how nominal and real rates are connected. The Risk-Free Rate Spreadsheet contains a tab marked Real & Nominal Rates-Theory. This tab does the computations for the following thought experiment. Imagine that we're interested in investing $100 in the capital market for 10 years, but we're not interested in taking any risk. Our investment option is therefore U.S. government securities. In the actual capital markets the discount rate on U.S. government securities is determined in a large, very liquid auction so no one can 'set' the rate by themselves (legally anyway). However, here we are going to pretend we can set the nominal rate so we can demonstrate the effect of the nominal risk- free rate as well as different inflation environments on our real investment returns. In doing so, we will gain some intuition about nominal rates, real rates, and inflation. We want to set the nominal interest rate in the spreadsheet so that we get compensated in actual goods and services for waiting at the market rate. Let's say that the real risk-free rate is 3%. Suppose further that they only thing we consume is pizza and that we can currently buy 5 pizzas for our $100 investment. Please use the spreadsheet to address the following questions. 3. Start by setting the inflation rate in the spreadsheet to 0% and the nominal rate equal to 3%. a. How much do we expect to get paid in 10 years in return for our $100 investment now? How many pizzas will we be able to buy in 10 years with our money? 4. Now set the inflation rate to 25% and leave the nominal rate equal to 3%. a. How much will we get paid in 10 years? b. How many pizzas will we be able to buy with the money we receive? c. Are we better or worse off than we were in question 3) above? Part 2: Real and Nominal Risk-free Rates-Theory In Part 2, we are going to explore the concept of nominal and real risk-free rates. The nominal risk-free rate tells us how many additional pictures of Geo. Washington we will receive in the future in return for an investment in a risk-free security such as U.S. government bonds. The real risk-free rate tells us how much more physical stuff we will be able to consume in the future in return for an investment in a risk- free security. Since we no longer use the barter system as a means of exchange, most interest rates, including risk-free rates, are quoted in nominal terms. Thus, unless otherwise stated, any risk-free rate is assumed to be a nominal rate. The difference between nominal and real rates is the inflation rate. For instance, in problem 1 above, we were promised $1,040 pictures of Geo. Washington in the future for a $1,000 investment now. This is a nominal rate-we are to receive 40 extra pictures of Washington in exchange for the U.S. government using our money for a year. However, we don't care about pictures of Geo. Washington per se. What we really care about is how much we can buy with the dollars we receive. The real rate tells us how much we will receive in terms of goods and services rather than pictures of Washington. Let's do an exercise to see how nominal and real rates are connected. The Risk-Free Rate Spreadsheet contains a tab marked Real & Nominal Rates-Theory. This tab does the computations for the following thought experiment. Imagine that we're interested in investing $100 in the capital market for 10 years, but we're not interested in taking any risk. Our investment option is therefore U.S. government securities. In the actual capital markets the discount rate on U.S. government securities is determined in a large, very liquid auction so no one can 'set' the rate by themselves (legally anyway). However, here we are going to pretend we can set the nominal rate so we can demonstrate the effect of the nominal risk- free rate as well as different inflation environments on our real investment returns. In doing so, we will gain some intuition about nominal rates, real rates, and inflation. We want to set the nominal interest rate in the spreadsheet so that we get compensated in actual goods and services for waiting at the market rate. Let's say that the real risk-free rate is 3%. Suppose further that they only thing we consume is pizza and that we can currently buy 5 pizzas for our $100 investment. Please use the spreadsheet to address the following questions. Part 2: Real and Nominal Risk-free Rates-Theory In Part 2, we are going to explore the concept of nominal and real risk-free rates. The nominal risk-free rate tells us how many additional pictures of Geo. Washington we will receive in the future in return for an investment in a risk-free security such as U.S. government bonds. The real risk-free rate tells us how much more physical stuff we will be able to consume in the future in return for an investment in a risk- free security. Since we no longer use the barter system as a means of exchange, most interest rates, including risk-free rates, are quoted in nominal terms. Thus, unless otherwise stated, any risk-free rate is assumed to be a nominal rate. The difference between nominal and real rates is the inflation rate. For instance, in problem 1 above, we were promised $1,040 pictures of Geo. Washington in the future for a $1,000 investment now. This is a nominal rate-we are to receive 40 extra pictures of Washington in exchange for the U.S. government using our money for a year. However, we don't care about pictures of Geo. Washington per se. What we really care about is how much we can buy with the dollars we receive. The real rate tells us how much we will receive in terms of goods and services rather than pictures of Washington. Let's do an exercise to see how nominal and real rates are connected. The Risk-Free Rate Spreadsheet contains a tab marked Real & Nominal Rates-Theory. This tab does the computations for the following thought experiment. Imagine that we're interested in investing $100 in the capital market for 10 years, but we're not interested in taking any risk. Our investment option is therefore U.S. government securities. In the actual capital markets the discount rate on U.S. government securities is determined in a large, very liquid auction so no one can 'set' the rate by themselves (legally anyway). However, here we are going to pretend we can set the nominal rate so we can demonstrate the effect of the nominal risk- free rate as well as different inflation environments on our real investment returns. In doing so, we will gain some intuition about nominal rates, real rates, and inflation. We want to set the nominal interest rate in the spreadsheet so that we get compensated in actual goods and services for waiting at the market rate. Let's say that the real risk-free rate is 3%. Suppose further that they only thing we consume is pizza and that we can currently buy 5 pizzas for our $100 investment. Please use the spreadsheet to address the following questions. 3. Start by setting the inflation rate in the spreadsheet to 0% and the nominal rate equal to 3%. a. How much do we expect to get paid in 10 years in return for our $100 investment now? How many pizzas will we be able to buy in 10 years with our money? 4. Now set the inflation rate to 25% and leave the nominal rate equal to 3%. a. How much will we get paid in 10 years? b. How many pizzas will we be able to buy with the money we receive? c. Are we better or worse off than we were in question 3) above? 3. Start by setting the inflation rate in the spreadsheet to 0% and the nominal rate equal to 3%. a. How much do we expect to get paid in 10 years in return for our $100 investment now? How many pizzas will we be able to buy in 10 years with our money? 4. Now set the inflation rate to 25% and leave the nominal rate equal to 3%. a. How much will we get paid in 10 years? b. How many pizzas will we be able to buy with the money we receive? c. Are we better or worse off than we were in question 3) above?
Expert Answer:
Answer rating: 100% (QA)
To address the questions well use the RiskFree Rate Spreadsheet provided in the exercise 3 Sta... View the full answer
Related Book For
Posted Date:
Students also viewed these finance questions
-
Planning is one of the most important management functions in any business. A front office managers first step in planning should involve determine the departments goals. Planning also includes...
-
Managing Scope Changes Case Study Scope changes on a project can occur regardless of how well the project is planned or executed. Scope changes can be the result of something that was omitted during...
-
In your opinion, was Saks' zero tolerance policy for employee theft reasonable? Was the policy likely cost-effective? Defend your answers.
-
Elijah is single. He holds a $12,000 AMT credit from 2015. In 2016, his regular tax liability is $28,000 and his tentative minimum tax is $24,000. Does Elijah owe AMT in 2016? How much (if any) of...
-
Discuss the advantages and disadvantages of the proposal that there should be a separate category of asset in the statement of financial position clearly identified as research investment outcome...
-
True or False: If \(\operatorname{IRR}(\mathrm{A})>\operatorname{IRR}(\mathrm{B})\), then \(\operatorname{ERR}(\mathrm{A})>\operatorname{ERR}(\mathrm{B})\).
-
The financial statements of P&G are presented in Appendix 5B or can be accessed at the books companion website, www.wiley.com/college/kieso. Instructions Refer to these financial statements and the...
-
assumption 1 assume there will be 4000 visits, each visit will yield 1400 of revenue
-
The first quarter tax return needs to be filed for Prevosti Farms and Sugarhouse by April 15, 2021. For the taxes, assume the second February payroll amounts were duplicated for the March 5 and March...
-
Your credit risk manager at Caulfield Bank has provided you with the following information about market yield curves. The 1 year risk free Treasury Bonds is 0.2% and the 2 year risk free Treasury...
-
You are currently in school to get your associate degree for health services Administration the portfolio project was based on this : You have volunteered to organize a fundraiser for your child's...
-
Explain the differences between defined contribution and defined benefits plans, also include their benefits and shortfalls
-
What policies, is any, should employers develop concerning the use of social media for various purposes, including employee recruitment and selection
-
In late adulthood, there are changes that occur physically and cognitively which are at times difficult for the individual to embrace. Please share at least2physical (one must relate to sex or...
-
Why is it important to provide employees feedback on performance? What are the ramifications if we don't
-
Consider the circuit in Fig, and assume that R, = 1.5 M Q, R, < 2.5 MQ. (a) Calculate the extreme limits of the time constant of the circuit. (b) How long does it take for the lamp to glow for the...
-
Identify one local business that uses a perpetual inventory system and another that uses a periodic system. Interview an individual in each organization who is familiar with the inventory system and...
-
One of the major reasons for engineoil degradation is the oxidation of the motor oil. To retard the degradation process, most oils contain an antioxidant. Without an inhibitor to oxidation present,...
-
The formation of propenol on a catalytic surface is believed to proceed by the following mechanism O2+2Scat2OSC3H6+OS C3HOHSC3HOHS C3HOH+S Suggest a rate-limiting step and derive a rate law.
-
The elementary gas-phase reaction A + B 2C is carried out in a packed-bed reactor. The entering molar flow rates are F A0 = 5 mol/s, F B0 = 2FA0, and FI = 2FA0 with C T0 = a. Write the mole balance,...
-
Explain how an ABS is structured.
-
Explain how an ABS CDO is structured.
-
Why do you think we would want to draw these two extra lines onto the handwritten account?
Study smarter with the SolutionInn App