Part 2: Real and Nominal Risk-free Rates-Theory In Part 2, we are going to explore the concept of nominal and real risk-free rates. The nominal risk-free rate tells us how many additional pictures of Geo. Washington we will receive in the future in return for an investment in a risk-free security such as U.S. government bonds. The real risk-free rate tells us how much more physical stuff we will be able to consume in the future in return for an investment in a risk- free security. Since we no longer use the barter system as a means of exchange, most interest rates, including risk-free rates, are quoted in nominal terms. Thus, unless otherwise stated, any risk-free rate is assumed to be a nominal rate. The difference between nominal and real rates is the inflation rate. For instance, in problem 1 above, we were promised $1,040 pictures of Geo. Washington in the future for a $1,000 investment now. This is a nominal rate-we are to receive 40 extra pictures of Washington in exchange for the U.S. government using our money for a year. However, we don't care about pictures of Geo. Washington per se. What we really care about is how much we can buy with the dollars we receive. The real rate tells us how much we will receive in terms of goods and services rather than pictures of Washington. Let's do an exercise to see how nominal and real rates are connected. The Risk-Free Rate Spreadsheet contains a tab marked Real & Nominal Rates-Theory. This tab does the computations for the following thought experiment. Imagine that we're interested in investing $100 in the capital market for 10 years, but we're not interested in taking any risk. Our investment option is therefore U.S. government securities. In the actual capital markets the discount rate on U.S. government securities is determined in a large, very liquid auction so no one can 'set' the rate by themselves (legally anyway). However, here we are going to pretend we can set the nominal rate so we can demonstrate the effect of the nominal risk- free rate as well as different inflation environments on our real investment returns. In doing so, we will gain some intuition about nominal rates, real rates, and inflation. We want to set the nominal interest rate in the spreadsheet so that we get compensated in actual goods and services for waiting at the market rate. Let's say that the real risk-free rate is 3%. Suppose further that they only thing we consume is pizza and that we can currently buy 5 pizzas for our $100 investment. Please use the spreadsheet to address the following questions. 3. Start by setting the inflation rate in the spreadsheet to 0% and the nominal rate equal to 3%. a. How much do we expect to get paid in 10 years in return for our $100 investment now? How many pizzas will we be able to buy in 10 years with our money? 4. Now set the inflation rate to 25% and leave the nominal rate equal to 3%. a. How much will we get paid in 10 years? b. How many pizzas will we be able to buy with the money we receive? c. Are we better or worse off than we were in question 3) above?