A 1 year Treasury Security has a yield of 8%. The investor's expected annual rate of inflation is 4%. However, the actual annual rate of inflation was 3%.
1. What is the expected real rate of interest?
2. What is the actual realized rate of interest?
The mathematics for real and actual realized rate of return is straightforward. Whatever is the yield, inflation erodes it. This is so because inflation actually reduces the purchasing power of each dollar you save or invest.
1. Calculating Expected Real Rate of Interest- this will be yield minus the expected rate of inflation
Hence, Expected Real Rate of Interest= Treasury Security Yield- Expected Annual Rate of Inflation= 8%-4%= 4%
2. Calculating Actual Realized Rate of Interest- this will be yield minus the actual rate of inflation
Hence, Actual Realized Rate of Interest= Treasury Security Yield- Actual Annual Rate of Inflation= 8%-3%= 5%
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