Question

a. What is realised real interest rate? Can a change in expected inflation rate affect the realised real interest rate? Explain.

b. Suppose that there is an increase in expected inflation rate from 3 percent to 6 percent. Given that the after-tax expected real interest rate remains unchanged at 2 percent and the tax rate is 30 percent, find the original and the new nominal interest rates.

c. Suggest ONE way in which investors can reduce/avoid the risk of unexpected inflation.

Answer 1

1. Realised real interest rate in the rate of interest realised after taking out the effects of inflation. Put it simply Real Interest rate = Nominal Interest rate - Inflation.

Change in expected inflation do not affect the Realised real interest rate as it used the actual rate of inflation into its calculation which is different than the expected rate of inflation.

2. Before tax Real rate = 2/0.7=> 2.857%

Original Nominal Interest rate = 2.857*(1+0.03) => 2.942%

New Nominal Interest rate = 2.857*(1+0.06) => 3.028%

3. Buying TIPS (Treasury Inflation Protected Securities) assures investors to avoid the risk of unexpected inflation as returns and principal are inflation adjusted. Therefore TIPS allowas one to secure a fixed real rate of return.

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