Expected Effect of Inflation on Nominal Risk-Free Rate | CFA Level 1 Exam Prep

Effect of Inflation on Nominal Risk-Free Rate

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Question

Suppose the inflation rate in the United States is expected to increase from 3% to 4.25% per year in the next year. Assume the current quoted risk-free rate of interest, as measured by the nominal rate on U.S. Treasury 10-year notes, is 5.25% per year. Further, assume that the news of an increase in inflation has not been factored into the risk-free rate. Given this information, what is the expected effect in the nominal risk-free rate? Assume that the inflation-free rate of interest and the inflation premium are not significantly large.

Answers

A. Risk-free rate will decrease by 125 basis points

B. The answer cannot be calculated from the information provided.

C. Risk-free rate will increase by 42 basis points

D. None of these answers is correct.

E. Risk-free rate will increase by 417 basis points

F. Risk-free rate will increase by 125 basis points

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Explanations

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A. B. C. D. E. F.

Remember that the nominal risk-free rate of interest is comprised of two components, the real "inflation-free" rate of interest, and an inflation premium. The inflation premium is equal to the anticipated inflation rate.

The equation for the calculation of the nominal interest rate in situations where the real inflation-free rate of interest and/or the inflation premium are low is as follows:

Risk-free rate of return = k* + IP

where: k* = the real inflation-free rate of return and IP = the inflation premium

In this example, the anticipated inflation rate, IP, has increased by 125 basis points. The effect of this increase will be mirrored by an equal increase in the real-risk free rate of interest.

When either the real "inflation-free" interest rate or the expected inflation rate are significantly large, the calculation of the nominal risk-free rate differs from the equation used when these factors are significantly small. Specifically, the calculation of the nominal risk-free rate of interest when theinflation-free rate of interest and/or the inflation premium are significantly high, the calculation of the nominal risk-free rate is as follows:

Nominal RFR = (1 + Real RFR)(1 + E(I)) - 1

Where: Real RFR = the real inflation-free rate of interest and E(I) = the anticipated inflation rate

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