Nominal Risk-Free Rate of Interest and Inflation Premium - CFA Level 1 Exam

Inflation Premium

Prev Question Next Question

Question

Assuming that the nominal risk-free rate of interest is currently at 4.90% per year, with the real inflationfree rate of return at 2.05% per year, what is the inflation premium? Further, assuming that the inflation premium is to fall by 130 basis points, what would be the adjusted nominal risk-free rate of interest?

Assume that both the new inflation rate and the inflation-free rate of interest are considered small by historical standards.

Answers

A. 2.85% per year, increase by 70 basis points

B. 2.05% per year, increase by 130 basis points

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

D. 2.85% per year, increase by 130 basis points

E. None of these answers is correct.

F. 2.05% per year, decrease by 130 basis points

Show Answer

Explanations

Click on the arrows to vote for the correct answer

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 when the real inflation-free rate of interest and/or the inflation premium are significantly small 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 nominal risk-free interest rate is provided as 4.90%, and the inflation-free rate of return as 2.05%. Incorporating these values into the equation illustrated above will yield a value of 2.85% for the inflation premium.

Increasing the inflation premium by 130 basis points will lead to a 130 basis point increase in the nominal risk-free interest rate. None of the answers correctly illustrate these findings.

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 the inflation-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

Prev Question Next Question