Interest rate fundamentals: the real rate of return. Carl Foster, a trainee at a

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 today's marketplace. He has looked up the rate paid on 3-month US Treasury bills and found it to be 55% He has decided to use the rate of change in the Consumer Price Index as a proxy for the inflationary expectations of investors. That annualized rate now stands at 2%. Based on the information that Carl has collected, what estimate can he make of the real rate of return?

Explanation / Answer

Nominal rate = 5.5%

Inflation expectations = 2%

Now nominal rate = real rate + inflation

This is because the real rate of return effectively will decrease or in other words, the purchasing power will decrease due to inflation.

So 5.5% = real rate + 2%

Real rate of return = 3.5%

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