Going from nominal to real rates

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I am referring to reading 10 (estate planning) where a formula is used to go from nominal to real risk free rate. The formula is 1+nominal/1+inflation. I know I had seen this method of removing inflation in a variety of other places in level I and II but for whatever reason I always add or subtract inflation to go from nominal to real rates. I don’t really comprehend why the multiplication/division method is used. For example if I have a $100 and the real risk free rate is 2% then I get $102 without including inflation. If inflation is 2% as well then I need $104 to maintain the my purchasing power. I wouldn’t need $102 X 1.02 would I? By assuming its 2% on the $102 we are implying we get the inflation premium on the real return as well as the principal.
I dont want to sweat the small stuff here but does it really matter which method I use for the exam? From my experience with levels I and II CFAI doesnt get that technical.
 
Somewhere in Curriculum is mentioned when compounded method should be used and when simple deduction or maybe Schweser provided such explanation, cannot remember where I found this . Anyway output shouldn’t be significantly different.
 
Understood and thank you for your reply. This is my first run at L3 so I suppose my point was that in level I and II, like you said, the output differential would still give you the right answer choosing between A, B or C but for L3 we need to arrive at a specific output from our own calculations. There are no choices. So if the compound method gives me $150 as an answer but simple deduction method gives me $152. Is that right or wrong?
 
Probably wrong if you supposed to chose exact solution between both choices mostly in vignette style question. I am not sure whether an exam grader would take as wrong manner of one calculation instead of another in open-type questions. This situation is reminding me on similar queries regarding calculating FX Forwards on add-on interest basis vs compounding.
 
Ya, true, same question I suppose. I remember people asking a lot questions around inconsistencies in calculating currency forward rates between the level II Econ method and the Level II derivatives section. In econ they used simple interest, in deriv they use compounding.
 
The exact formula for the real rate is (nominal - inflation)/(1 + inflation). Some use only nominal - inflation as an approximation. These correspond to your compound and subtraction methods you stated above. If inflation is low, the approximation works reasonably well.
 
(1+real) (1+inflation) = (1+nominal)
or real = (1+nominal) / (1+inflation) - 1
= (nominal - inflation)/(1+inflation)
– to expand on breadmaker’s post above.
 
(1+real) (1+inflation) = (1+nominal)
or real = (1+nominal) / (1+inflation) - 1
= (nominal - inflation)/(1+inflation)
– to expand on breadmaker’s post above.
 
Addition/subtraction generally.
Use multiplication if given the choice between both.
 
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