you bought a bond for $10,000. You received interest of $400 at the end of the year, as well as your $10,000 principal. If the inflation rate over the last year was five percent, calculate the real return.
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To calculate the real return, we need to consider the effect of inflation on the nominal return. The real return represents the adjusted return after accounting for inflation.
Step 1: Calculate the inflation-adjusted principal:
Inflation-adjusted principal = Principal / (1 + Inflation Rate)
Inflation Rate = 5% = 0.05
Inflation-adjusted principal = $10,000 / (1 + 0.05)
Inflation-adjusted principal = $10,000 / 1.05
Inflation-adjusted principal = $9,523.81
Step 2: Calculate the inflation-adjusted interest:
Inflation-adjusted interest = Interest / (1 + Inflation Rate)
Interest = $400
Inflation-adjusted interest = $400 / (1 + 0.05)
Inflation-adjusted interest = $400 / 1.05
Inflation-adjusted interest ≈ $380.95
Step 3: Calculate the real return:
Real Return = Inflation-adjusted principal + Inflation-adjusted interest - Principal
Real Return = $9,523.81 + $380.95 - $10,000
Real Return = $-95.24
The real return in this case is approximately -$95.24, indicating a negative return after accounting for the effect of inflation.