Question

Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 6.00% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

Answer 1

Answer:

Nominal rate of return (m) = 7%

Inflation rate (i) = 6% = 0.06

Real rate of return = ?

(1+m) = (1+r)(1+i)

(1+ 0.07) = (1 + r)(1 + 0.06)

(1.07)      = (1 + r)(1 .06)

1.07/1.06 = 1 + r

1.0094 = 1 + r

r = 1.0094 - 1

r = 0.0094 = 0.94%

Explanation:

In this case, we will apply the above formula where m is the nominal rate of return, i is inflation rate. We will make r the subject of the formula. r represents real risk-free rate.