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The real return on a bond is roughly equivalent to the nominal interest rate minus the expected inflation rate. But if actual inflation exceeds expected inflation during the life of the bond, the bondholder's real return will suffer. This risk is one of the reasons inflation-indexed bonds such as U.S. Treasury Inflation-Protected Securities ...
For instance, if a loan offers a 4% nominal interest rate and inflation is 2%, the real interest rate is approximately 2%. The world of finance has a somewhat different definition.
In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation (higher or lower).
For example, if the inflation rate is 5%, on a one-year loan of $1,000 with an 8% nominal interest rate the real interest rate would be 8% minus 5% or 3%. The real interest rate will usually be ...
The equation is an approximation; however, the difference with the correct value is small as long as the interest rate and the inflation rate is low. The discrepancy becomes large if either the nominal interest rate or the inflation rate is high. The accurate equation can be expressed using periodic compounding as:
Real value takes into account inflation and the value of an asset in relation to its purchasing power. In macroeconomics, the real gross domestic product compensates for inflation so economists can exclude inflation from growth figures, and see how much an economy actually grows. Nominal GDP would include inflation, and thus be higher.
The formula R = N-I approximates the correct answer as long as both the nominal interest rate and the inflation rate are small. The correct equation is r = n/i where r, n and i are expressed as ratios (e.g. 1.2 for +20%, 0.8 for −20%). As an example, when the inflation rate is 3%, a loan with a nominal interest rate of 5% would have a real ...
Generally taxes are imposed on nominal interest earnings, not adjusted for inflation. If the tax rate is denoted as t, the before-tax nominal earning rate is i, the amount of taxes paid (per dollar or other unit invested) is i × t, and so the after-tax nominal earning is i × (1–t). Hence the expected after-tax real return to the investor ...