Consider a bond with an annual interest rate of 5%, compounded annually. If the compounding period is exactly one year, the nominal rate and effective rate will be the same. The nominal and effective interest rates are not always different. n – Number of compounding periods per year.If the interest is compounded continuously, The relationship between a nominal rate and an effective rate with discrete compounding period adjustment is shown below: Compounding Adjustment of the Nominal Interest Rate Different effective interest rates can be compared directly since they’ve been adjusted to reflect the effect of compounding. It is calculated based on the nominal interest rate and its compounding periods. Therefore, nominal interest rates are not always comparable, unless they include the same compounding periods.Įffective interest rate is considered a more accurate measure of interest. It does not take compounding into account. The nominal interest rate refers to the periodic interest rate multiplied by the number of periods in a year. If the nominal interest rate and expected inflation rate both increase at the same rate, which means the inflation premium is compensated, the real interest rate will remain unchanged. The lender’s real return drops as a result of a faster decline in the purchasing power. I = (1 + R) (1 + h) – 1 = (1 + 5%) (1 + 3%) – 1 = 8.15%Īccording to the Fisher Effect, if the inflation rate increases and the nominal interest rate remains constant, the real interest rate will fall. The two methods of calculation give a similar result. The nominal interest rate can also be calculated through the formula below. Therefore, the investor should look for a bond with a stated (nominal) interest rate of 8% (5% + 3%). It states that the nominal interest rate is approximately equal to the real interest rate plus the inflation rate ( i = R + h).įor example, a bond investor is expecting a real interest rate of 5%, when the market shows an expected inflation rate of 3%. With a low inflation rate, a simplified version of the Fisher equation can be implemented. In a stable economy that is growing at a moderate pace, the inflation rate is usually low. The Fisher Effect describes the relationship between inflation and nominal or real interest rate through the equation below: (1 + i) = (1 + R) (1 + h) Inflation Adjustment of Nominal Interest Rate It is important for a lender to understand the real interest rate of a bond. The rate of return after adjusting the nominal interest rate for inflation is known as the real interest rate. Thus, the return that a lender earns for each dollar he lent before is actually lower than the rate stated in the contract. A nominal interest rate contains two parts: a real interest rate and an inflation premium.Īs an economy grows with inflation, the purchasing power of each dollar declines over time. The rate is known as the nominal rate, which is stated in the loan contract. Interest rate is the cost of borrowing or return of lending due to the time value of money. In contrast to effective interest rate, the nominal interest rate refers to the rate specified in the loan contract without adjusting for compounding.According to the Fisher Effect, nominal interest rate equals real interest rate plus the expected inflation rate.In contrast to the real interest rate, the nominal interest rate refers to the rate of interest before adjusting for inflation.
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