Tom is considering an investment with an expected rate of return of 12%. If the inflation rate is 3%, what is the real rate of return?

1 answer

To calculate the real rate of return, we can use the Fisher equation, which is given by:

\[ 1 + r = \frac{1 + i}{1 + \pi} \]

where:

  • \( r \) is the real rate of return,
  • \( i \) is the nominal rate of return (expected rate of return), and
  • \( \pi \) is the inflation rate.

In this case:

  • \( i = 0.12 \) (12%)
  • \( \pi = 0.03 \) (3%)

Plugging in the values:

\[ 1 + r = \frac{1 + 0.12}{1 + 0.03} = \frac{1.12}{1.03} \]

Calculating the right side:

\[ 1 + r = \frac{1.12}{1.03} \approx 1.0864 \]

Now, to find \( r \):

\[ r \approx 1.0864 - 1 = 0.0864 \]

Converting this back to a percentage:

\[ r \approx 0.0864 \times 100 \approx 8.64% \]

Therefore, the real rate of return is approximately 8.64%.