Real vs. Nominal and Inflation

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CFAbeatmeup

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Does anybody have any insight into real versus nominal as they relate to inflation? I thought nominal was stated and real included inflation. However in level 3 materials it seems the opposite on a host of formulas (Fixed Income Premium, GK, etc.). Can anybody provide insight?
 
Mr. Smart, I appreciate your help in the past, but this has been the third or fourth time I’ve been told to use Google by this board. It’s why I stopped coming to AF as much, to be honest. You don’t think I haven’t looked through my notes and attempted to find the answer myself? If it’s so simple, why not just include the link or give a keyword to help the search? Or, if you’re not going to help, why even respond?
 
Honestly, use google.
Here is the first paragraph when you search ‘real return’.
A real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time.
To be honest with you, I have no idea how you got this far without knowing the difference thus far. This is barely college material.
 
I’ll ignore your snark, but I still don’t understand why you have to add inflation to GK when the real rate of return includes inflation. So if you’re unwilling to help, just shut up and don’t respond.
 
You don’t understand because you did not read.
If you did read, then I guess I can’t help you.
 
Maybe you’re more of a numbers guy, see if this makes sense.
Nominal rate of return = Real rate of return + Historic inflation
 
Real rate does not include inflation. The Nominal rate is equal to the real rate + the rate of inflation. You seem to have it backwards @CFAbeatmeup.
 
I think people sometimes confuse real rate bonds with the real interest rate. Real rate bonds compensate you for inflation. The real interest rate is the nominal interest rate - the expected inflation rate.
 
Yes, it seems when calculating the required nominal after-tax rate of return (Individuals section); Nominal = real rate + inflation.
However, when asked what type of securities you would need for a pension plan that has inactive and active participants; nominal bonds are assumed to be real rate and thus you would require real-rate bonds (inflation-indexed) to take into account inflation.
Maybe someone could elaborate as to why there is this difference in terminology ?
 
Onestar wrote:
Yes, it seems when calculating the required nominal after-tax rate of return (Individuals section); Nominal = real rate + inflation.
However, when asked what type of securities you would need for a pension plan that has inactive and active participants; nominal bonds are assumed to be real rate and thus you would require real-rate bonds (inflation-indexed) to take into account inflation.
Maybe someone could elaborate as to why there is this difference in terminology ?
Click to expand...
Both compensate for inflation, but real rate bonds are a better hedge since it tracks actual inflation as it occurs. While nominal bonds prices in a fixed rate of inflation, which may change with time.
If the pension pays fixed benefits, use a fixed asset (nominal bond). If the benefit is indexed to inflation, then use a mix of both. Because inflation may be higher than the orignial expected inflation priced in the nominal bond, hence to minimize losses.
 
Thanks Mmarin3005. I guess the bonds did send me in a spin. I was just wrong in my initial thought and all is right in the world.
 
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