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MGT411 GDB Spring 2020 Solution & Discussion Last Date: 08-06-2020

MGT411 GDB 1 Solution and Discussion

Total Marks 5
Starting Date Wednesday, June 03, 2020
Closing Date Monday, June 08, 2020
Status Open
Question Title Nominal and Real Interest rate
Question Description

SEMESTER SPRING 2020

Money and Banking (MGT411)

GDB No. 1

Due Date: June 08, 2020 Marks: 5

Learning Objective:

The objective of this question is to enable the students to understand the difference in nominal interest rate and real interest rate and its importance for lenders and borrowers.

Discussion Question:

It is important to understand the difference between nominal interest rate and real interest rate. Nominal interest rate is expressed in terms of current dollars as used in present value calculation where the purpose is to assess the amount of money you would pay today for fixed payments in the future. In case of borrowers and lenders; inflation is another important factor as they are concerned about the purchasing power of money and there is possibility that inflation may change the purchasing power of dollars. So there is a need to use inflation adjusted interest rate that is real interest rate. It equals to nominal interest rate minus inflation and expressed in terms of purchasing power. This phenomenon is best expressed by Irving Fisher in the form of Fisher equation that states that nominal interest rate ‘i’ is equal to real interest rate ‘r’ plus expected inflation ‘πe’.

Keeping this in mind; answer the following questions:

If there are equal chances of being paid back; whether 8% nominal interest rate is more attractive to a lender or 5% nominal interest rate? Explain your answer.

Also explain in the context of Fisher equation; what compensation a borrower is giving to a lender when he pays nominal interest rate?

Important Instructions:

Your discussion must be based on logical facts.
The GDB will remain open for 07 working days.
Do not copy or exchange your answer with other students. Two identical / copied comments will be marked Zero (0) and may damage your grade in the course.
Obnoxious or ignoble answer should be strictly avoided.
Questions / queries related to the content of the GDB, which may be posted by the students on MDB or via e-mail, will not be replied till the due date of GDB is over.

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Replies to This Discussion

If there are equal chances of being paid back; whether 8% nominal interest rate is more attractive to a lender or 5% nominal interest rate? Explain your answer.

Nominal Interest Rate
The nominal interest rate is the stated interest rate of a bond or loan, which signifies the actual monetary price borrowers pay lenders to use their money. If the nominal rate on a loan is 5%, borrowers can expect to pay $5 of interest for every $100 loaned to them. This is often referred to as the coupon rate, because it was traditionally stamped on the coupons redeemed by bondholders.

  • KEY TAKEAWAYS
    The different types of interest rates, including real, nominal, effective and annual, are distinguished by key economic factors that can help individuals become shrewder investors.
    Real interest rates, unlike nominal rates, take account of inflation.
    Investors and borrowers should also be aware of the effective interest rate, which takes the concept of compounding into account.

Real Interest Rate
The real interest rate is so named, because unlike the nominal rate, it factors inflation into the equation, to give investors a more accurate measure of their buying power, after they redeem their positions. If an annually compounding bond lists a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is actually only 2%.

It’s feasible for real interest rates to be in negative territory, if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1%, if the inflation rate is 4%. A comparison of real and nominal interest rates can be calculated using this equation:

RR=Nominal Interest Rate − Inflation Rate
where:
RR = Real Rate of Return

It is important to understand the difference between nominal interest rate and real interest rate

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal interest rate refers to the interest rate before taking inflation into account.

MGT411 GDB Solution
Not always. Lenders are concerned with the real return they receive. If the higher nominal interest rate represents a higher real interest rate, then the lender will find it more attractive. If, however, it merely reflects higher expected inflation and the real return is lower, this is not to the benefit of the lender.
The Fisher equation is often used in situations where investors or lenders ask for an additional reward to compensate for losses in purchasing power due to high inflation.

MGT411 GDB no. 1 Solution 2020

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