Introduction:

In the financial and economic sector, if an individual lends a sum of money for a period of time or invests in certain securities, he expects a compensation for sacrificing his current consumption and consuming at a later point of time i.e. he expects to be compensated for Time Value of Money and in addition to this he also needs a compensation for the loss of purchasing power of the sum he has lent or invested, as he is going to be paid back his sum lent or invested after the expiry of a period of time. All these factors gave the basis for the derivation of a rate of interest which not only takes into consideration the time value of money but also the loss ofpurchasing power due to inflationary trend of prices in the economy and such rate was given the name of Nominal Risk Free Rate of Return. At Transtutors.com we have expert team of tutors who provides are available to assist at our homework help and assignment help section.

Meaning: Nominal Risk Free Rate of return is the interest rate that an investor expects to yield after adding Inflation Rate to the Real Risk Free Rate of Return; it can be obtained as: Real Risk Free Rate of Return + Inflation Rate.

Derivation: Nominal risk Free Rate can be derived as: (1+ Risk Free Real Rate)*(1+ Inflation Rate)

Thus if you are given with a Risk Free Real Rate of Interest as 3% and Inflation Rate is given as 5%, then the Nominal Risk Free Rate of Return can be calculated as below:

Nominal Risk Free Rate of Return = 1.03+1.05 = 8.15%.

Example: 10% corporate inflation protected securities is presently yielding 11%. The risk premium associated with the corporate securities is 3%. The expected inflation is 4%. What should be the required rate of return from a 10 year treasury security?

The required rate of return for a treasury security would be nominal risk free rate of return. The rate of return of corporate inflation protected securities would be Risk adjusted real rate of return. Given risk premium of 3% and expected inflation of 4%, the nominal risk free rate would be:

Nominal Risk Free Rate of Return = [<(1.11)/(1.03)>*1.04] 1 = 12.08%

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Types of Investment Risks covered by Nominal Risk Free Rate:

Interest Rate Risk:

Interest Rate Risk is the variability in a securities return resulting from changes in the level of interest rates. Other things remaining unchanged, security prices move inversely to the interest rates. This risk affects bondholders more directly than the equity investors. Homework help and assignment help section at Transtutors.com provides clear concept of all topics related with finance.

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