Question

Suppose you purchase a $5,000 bond that pays 7% interest annually and matures in five years. If the inflation rate during the next five years is 4%, the estimated real rate of return is

Answer 1

Answer:

2.88%

Explanation:

Use the following formula to calculate the real rate of return

Real rate of return = $\frac{( 1 + Nominal interest rate )}{( 1 + inflation rate)} -1$

Where

Nominal Interest rate = 7% = 0.07

Inflation rate = 4% = 0.04

Placing values in the formula

Real rate of return = $\frac{( 1 + 0.07 )}{( 1 + 0.04)} -1$

Real rate of return = $\frac{1.07}{1.04} -1$

Real rate of return = 1.0288 - 1

Real rate of return = 0.0288

Real rate of return = 2.88%