Nominal Rate of Return Chapter Notes | Applied Mathematics for Class 11 - Commerce PDF Download

Introduction

• The nominal rate of return is a key concept in finance that measures the rate of return on an investment before adjusting for inflation.
• It provides important insights into the potential earnings of an investment without considering the impact of changes in purchasing power due to inflation.

Components of Nominal Rate of Return

• Real Rate of Return: The real rate of return represents the actual increase in purchasing power resulting from an investment after accounting for inflation. It is the nominal rate of return adjusted for inflation.
• Inflation Rate: Inflation rate is the rate at which the general level of prices for goods and services is rising, and subsequently, the purchasing power of currency is falling. It reflects the erosion in the value of money over time.
• Risk Premium: Depending on the investment, a risk premium may be added to the nominal rate of return to compensate investors for the additional risk associated with the investment.

Calculation of Nominal Rate of Return

The nominal rate of return (R_n) can be calculated using the formula:
R_n = R_r + π + RP
Where:

• R_n = Nominal Rate of Return
• R_r = Real Rate of Return
• π = Inflation Rate
• RP = Risk Premium

Significance of Nominal Rate of Return

• Helps investors assess the potential returns on their investments without considering inflation.
• Enables comparison of returns across different investment options.
• Provides insight into the relationship between expected returns and inflation expectations.

Factors Influencing Nominal Rate of Return

• Inflation Expectations: Changes in expected inflation rates can directly impact the nominal rate of return. Higher expected inflation may lead to higher nominal returns.
• Risk Profile of Investment: Investments with higher risk profiles often require higher nominal rates of return to compensate investors for the additional risk undertaken.
• Market Conditions: Overall market conditions, including interest rates, economic growth prospects, and investor sentiment, can influence nominal rates of return.

Practical Examples

Example 1: Bonds: Consider a bond offering a real rate of return of 2%, and the expected inflation rate is 3%. The risk premium for the bond is 1%. Calculate the nominal rate of return.
Ans:

• R_r = 2%
• π = 3%
• RP = 1%
• R_n = 2% + 3% + 1% = 6%

The nominal rate of return on the bond is 6%.

Example 2: Stocks: Assume a stock provides a real rate of return of 5%. If the expected inflation rate is 2% and the risk premium is 3%, calculate the nominal rate of return.
Ans:

• R_r = 5%
• π = 2%
• RP = 3%
• R_n = 5% + 2% + 3% = 10%

The nominal rate of return on the stock is 10%.

Conclusion

Understanding the nominal rate of return is crucial for investors to make informed decisions regarding their investment portfolios. By considering both the nominal rate of return and its components, investors can better assess the potential risks and rewards associated with their investments in various market conditions.