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. Fisher equation The relation between real and nominal interest rates and the expected inflation rate is given by the Fisher equation 1+i = (1+r) (1+\pi^e) where i = nominal interest rate; r = real interest rate; π = expected inflation rate. For example, if somebody lends $1000 for a year at 10%, and receives $1100 back at the end of the year, this represents a 10% increase in her purchasing power if prices for the average goods and services that she buys are unchanged from what they were at the beginning of the year. However, if the prices of the food, clothing, housing, and other things that she wishes to purchase have increased 25% over this period, she has in fact suffered a real loss of about 12% in her purchasing power. Variations in inflation The inflation rate will not be known in advance. People often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The real interest rate ex post may turn out to be quite different from the real interest rate that was expected in advance. Borrowers hope to repay in cheaper money in the future, while lenders hope to collect on more expensive money. When inflation and currency risks are underestimated by lenders, then they will suffer a net reduction in buying power. The complexity increases for bonds issued for a long term, where the average inflation rate over the term of the loan may be subject to a great deal of uncertainty. In response to this, many governments have issued real return bonds, also known as inflation-indexed bonds, in which the principal value and coupon rises each year with the rate of inflation, with the result that the interest rate on the bond approximates a real interest rate. (E.g., the three-month indexation lag of TIPS can result in a divergence of as much as 0.042% from the real interest rate, according to research by Grishchenko and Huang.[2]) In the US, Treasury Inflation Protected Securities (TIPS) are issued by the US Treasury. The expected real interest rate can vary considerably from year to year. The real interest rate on short term loans is strongly influenced by the monetary policy of central banks. The real interest rate on longer term bonds tends to be more market driven, and in recent decades, with globalized financial markets, the real interest rates in the industrialized countries have become increasingly correlated. Real interest rates have been low by historical standards since 2000, due to a combination of factors, including relatively weak demand for loans by corporations, plus strong savings in newly industrializing countries in Asia. The latter has offset the large borrowing demands by the US Federal Government, which might otherwise have put more upward pressure on real interest rates. Related is the concept of risk return, which is the rate of return minus the risks as measured against the safest (least-risky) investment available. Thus if a loan is made at 15% with an inflation rate of 5% and 10% in risks associated with default or problems repaying, then the risk adjusted rate of return on the investment is 0%.
Posted on: Sun, 20 Jul 2014 12:48:47 +0000