A portfolio manager with Churn Brothers Brokerage Company is asked to provide an a registered representative with a figure for the "risk-free interest rate." The portfolio manager references the quoted rate on U.S. Treasury 10-year notes, currently at 4.75% per year, and uses this rate as the risk-free interest rate.
Which of the following best describes the rate referenced by this portfolio manager? Further, what two components comprise this rate?
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A. B. C. D. E. F.C
The risk-free rate as measured by the rate on U.S. Treasury securities often referred to as the "nominal," or "quoted," rate. This rate is comprised of two components, the real "inflation-free" rate of interest, and an inflation premium that is equal to the anticipated rate of inflation. The equation for the calculation of the nominal interest rate is as follows:
Risk-free rate of return = k* + IP
where: k* = the real inflation-free rate of return and IP = the inflation premium
An increase in anticipated inflation will cause a change in the nominal risk-free rate equal to the change in expected inflation. For instance, if the inflation premium increases by 100 basis points, then the nominal risk-free interest rate will increase by 100 basis points. Further, if the inflation-free rate of interest experiences a change, that change will be identically mirrored in the nominal risk-free interest rate. For example, suppose the inflation-free rate of interest decreases by 50 basis points. In this situation, the result would be a 50 basis point reduction in the nominal 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.