Due to an impending recession in the industrial and high tech sectors, combined with dramatic mismanagement of U.S. fiscal policies, the U.S. economy is expected to slip into a significant recession.
Given this shift, the U.S. inflation rate is expected to decrease significantly from its current level.
Specifically, the inflation rate is expected to decrease from 4.0% to a deflationary (2)% per year, and this decrease should be considered significantly large by historical standards. The current nominal interest rate in the U.S., as measured by the quoted rate on U.S. 10-year notes, is 8.25% per year. Further, the real inflation-free rate of interest is currently at 4.25%, and this rate is not anticipated to change. Assuming this decrease in inflation has not been factored in, what is the appropriate value for the nominal risk-free rate?
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A. B. C. D. E. F.A
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.
In this example, all of the necessary inputs have been provided. Imputing these values into the equation above will yield the following:
Nominal risk-free interest rate = {[(1 + 0.0425)(1 - 0.02) - 1] * 100} = 2.165%
When the inflation-free rate of interest and/or the inflation premium are low, then the equation above can be simplified to the following:
Nominal RFR = Real RFR + Inflation premium.
If you chose 2.25%, remember that when the real inflation-free rate of interest and/or the inflation premium are significantly large, the calculation of the nominal risk-free rate must involve a different equation than when these rates are small.