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Inflation and Real Rates of Return
Finance & Accounting
Pages 6 (1506 words)
1. Inflation and real rates of return a. b. 3.4% c. d. Inflation is the rise in the general price level for goods and services in an economy over a given period of time. The effect of inflation is that it reduces the consumer’s purchasing power. One dollar now buys fewer amounts of goods and services.
Real interest rates can be positive as well as negative. A positive real interest rate indicates that the purchasing power of the individual is increasing while a negative interest rate shows that the purchasing power of the individual is decreasing if the individual invests at the nominal rate. From the calculations above, it can be understood that at the current level of inflation, if a person invests in 1-year Certificate of Deposits, he will end up with less purchasing power. It can be analysed in such a way that a higher inflation rate than the nominal interest rate means that the purchasing power is decreasing at a faster rate than the rate of return of the investment. 2. Duration (Bonds) a. Frederick Macaulay developed a method to measure the interest rate risk of a bond and called it Macaulay Duration. He felt that duration is a better “measure of the bond’s worth than its time to maturity because duration considers both the repayment of capital at maturity and the size and timing of coupon payments before maturity” (Macaulay Duration). Macaulay Duration is the weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price (Macaulay Duration Definition). Duration measures a bond’s price sensitivity to interest rate changes. ...
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