Question

Suppose the nominal, risk free rate is 8.0% when the inflation rate is 5%. If the rate of inflation doubles, what will the new, nominal rate be?

Closest to a. 15.9 % b. 12.9 % c. 16.0 % d. 13.1 %

Answer 1

The nominal rate of return is computed as shown below:

Nominal rate of return = [ (1 + real rate of return) x (1 + inflation rate) ] - 1

0.08 = [ (1 + real rate of return ) x (1 + 0.05) ] - 1

(1.08 / 1.05) - 1 = real rate of return

0.028571429 = real rate of return

So, the new nominal rate of return will be computed as follows:

= [ (1 + real rate of return) x (1 + inflation rate) ] - 1

= [ (1 + 0.028571429) x (1 + 0.10) ] - 1

= 13.1% Approximately

So, the correct answer is option d.

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