Question

Interest rate fundamentals: The real rate of return Carl Foster, a trainee at an investment banking firm, is trying to get an idea of what real rate of return investors are expecting in todays marketplace. He has looked up the rate on 3-month U.S. Treasury bills and found it to be 1.5%. He has decided to use the recent rate of change in the Consumer Price Index as a proxy for the inflationary expectations of investors. That annualized rate now stands at 0.5%. On the basis of the information that Carl has collected, what estimate can he make of the real rate of return?

Answer 1

Real Rate of Return

The real rate of return is the actual annual percentage returns/profits that can be earned on an investment. The real rate of return takes into consideration the inflation rate (an increase in the general price levels of goods & services in an economy) and hence it gives a more accurate picture of the purchasing power of an investor for a given amount of money over a period of time.

The formula to calculate the real rate of interest is as follows:

Real rate of interest = Nominal rate of Interest - Inflation rate

In this case, Carl Foster found the Nominal interest rate of an investment (proxied by 3months US Treasury Bills rate) to be 1.5% and the inflation rate (proxied by consumer Price Index) to be 0.5%. Therefore, the real rate of interest (as per these data points) would be 1% (i.e. 1.5%-0.5%). Therefore, Carl should understand that after adjusting for inflation, an investor can make a profit of 1% per annum on his investment.

For example, An investor has invested $10,000 in a project. As per the nominal interest rate (i.e. 1.5%) he would be able to make profits (or returns) of $150 in a year (i.e. 1.5% of $10,000). But inflation (or the prices of goods and services would also rise by that time, therefore, reducing the purchasing power or value of $10,000) would rise by 0.5% (i.e. purchasing power would be reduced by $50) making the real rate of return on the investment to be $100 (i.e. $150-$50 or 1% of $10,000).