Real Interest Rate

A Real Interest Rate is an interest rate which includes systematic, regulatory risks.

• Context:
  • It can be estimated as the nominal interest rate minus the inflation rate.
• Counter-Example(s)
  • Nominal Interest Rate.
  • Effective Interest Rate
• See: Interest Rate, Compound Interest, Annual Percentage Rate, Annual Percentage Yield, Certificate of Deposit, Internal Rate of Return.

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References

2016

• (Wikipedia, 2016) ⇒ http://en.wikipedia.org/wiki/Real_interest_rate
  • The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate. If, for example, an investor were able to lock in a 5% interest rate for the coming year and anticipated a 2% rise in prices, they would expect to earn a real interest rate of 3%. This is not a single number, as different investors have different expectations of future inflation. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

[...] In economics and finance, an individual who lends money for repayment at a later point in time expects to be compensated for the time value of money, or not having the use of that money while it is lent. In addition, they will want to be compensated for the risks of having less purchasing power when the loan is repaid. These risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the loan will prove to be less valuable than estimated. The second includes taxation and changes in the law which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated. The third takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, that is inflation, and may include fluctuations in the value of the currencies involved.

Nominal interest rates include all three risk factors, plus the time value of the money itself.

Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money.

Real rates = Nominal rates minus Inflation and Currency adjustment.

The "real interest rate" in an economy is often the rate of return on a risk free investment, such as US Treasury notes, minus an index of inflation, such as the CPI, or GDP deflator. [...] The relation between real and nominal interest rates and the expected inflation rate is given by the Fisher equation

[math]\displaystyle{ 1+i = (1+r) (1+\pi_e) }[/math]

where

i = nominal interest rate;

r = real interest rate;

[math]\displaystyle{ \pi_e }[/math] = expected inflation rate.

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