The Nominal Risk-Free Rate of Return

Explanation

The nominal risk-free rate of return is simply the real risk-free rate adjusted for inflation. The real risk-free rate is the absolute minimum rate that any investor would require.

The correct answer is B. (1 + the real risk-free rate of return) x (1 + the expected rate of inflation) - 1.

Let's break down the components of this answer to understand why it represents the nominal risk-free rate of return:

1. Real risk-free rate of return: The real risk-free rate of return represents the theoretical rate of return on an investment with no risk, i.e., an investment with no possibility of default or loss. It is the rate of return an investor would require to invest in a completely risk-free asset. However, in the real world, there is always some level of risk associated with investments. To account for this, we adjust the real risk-free rate of return by incorporating expected inflation.

2. Expected rate of inflation: Inflation is the general increase in prices over time. It erodes the purchasing power of money. To maintain the same level of purchasing power, an investor needs to earn a return that compensates for the expected rate of inflation. The expected rate of inflation represents the anticipated increase in prices over a specific period.

Now, let's understand how these two components come together to calculate the nominal risk-free rate of return:

• Step 1: Add 1 to the real risk-free rate of return. This adjustment accounts for the required rate of return on a completely risk-free investment.
• Step 2: Add 1 to the expected rate of inflation. This adjustment reflects the anticipated increase in prices.
• Step 3: Multiply the results of Step 1 and Step 2. This multiplication accounts for the compounding effect of both the real risk-free rate and the expected rate of inflation.
• Step 4: Subtract 1 from the result of Step 3. This final step adjusts for the fact that the nominal risk-free rate of return is expressed as a percentage.

By following these steps, we obtain the nominal risk-free rate of return, which represents the rate of return an investor would expect to earn on an investment with no risk, considering both the real risk-free rate and the expected rate of inflation.

Therefore, answer choice B. (1 + the real risk-free rate of return) x (1 + the expected rate of inflation) - 1 correctly represents the calculation for the nominal risk-free rate of return.