Question

Financial managers and investors want to know what is the real rate of interest? Provide an illustrative example of how the real rate of interest applies to you personally. How does this concept impact how you will view investments in your future?   Describe how the acquired knowledge on the real rate of interest can be adopted into your daily life style.

Answer 1

Solution:-

In simplest of words, the value of currency notes is not true in terms of the numbers it display on top of it but in terms of the purchasing power they hold. If a $10 bill can buy more today than what a $20 would be able to buy in 2 years, than an investor who doubled his money in 2 years essentially made no returns on his investments.

We are referreing to the role of inflation in investment analysis. Due to inflationary pressures, the money loses its value over a period of time, and that's why it becomes super important that every investor analyses his investment returns based on increase in his real purchasing power rather than on abolsute nominal terms.

This is why Every investor must consider real rate of return while making his investments so that he can take an informed and appropriate decision.

Financial managers and investors want to know the real rate of interest because it sets a benchmark of the real returns they should expect from their investment portfolio, adjusted for its risk. While comparing a set of investment options, we must compare their real rates of returns adjusted for their individual risks and only than can we make an accurate decision.

An example of how it impacts us personally would be a person wanting to get a fixed deposit with a bank. If he sees that bank is offering a nominal interest rate of 5% while the inflation is expected to be at 6%, it means that the real rate of interest becomes -1%. This means that his money will actually decrease in real terms if invested in that fixed deposit, thus helping the person to take an informed decision.

It impacts us significantly in the way we see our investments in future because this turns our focus on the real rate of return on our investments rather than what they offering on absolute basis. We get concerned by increase in our true wealth through purchasing power rather than just increase in nominal value.

In our daily lifestyle, whether we are taking a loan, making an investment, buying a house, buying a car, taking credit card loans, paying for college tution, or pretty much anything else, all our finance related decisions must consider the impact of inflation and thus take into account real rate of interest. For example: If the college tuition of a college is $10,000 per year to be paid for the next 3 years while of another college is $30,000 for three years to be paid upfront together, than we must compare them by taking in the impact of real rate of interest and inflation before we arrive at the true financial comparision of the two colleges.