The nominal risk-free rate of interest on a bond with a real rate of 1.25% and expected inflation of 1.5%, using the approximation and the precise formulas, respectively, are closest to:

$\begin{array}{llcc}
& \text{ Approximation} & \text{ Precise} \\end{array}$

Question

The nominal risk-free rate of interest on a bond with a real rate of 1.25% and expected inflation of 1.5%, using the approximation and the precise formulas, respectively, are closest to:

$\begin{array}{llcc}
& \text{ Approximation} & \text{ Precise} \\end{array}$

Quizplus · Accepted Answer

The approximation formula for the nominal risk-free rate is given by: $r = r_{real} + \text{Inflation rate}$, which gives $1.25\% + 1.5\% = 2.75\%$. The precise formula is $r = (1 + r_{real}) \times (1 + \text{Inflation rate}) - 1$, which calculates to $(1 + 0.0125) \times (1 + 0.015) - 1 = 2.769\%$.

The Nominal Risk-Free Rate of Interest on a Bond with a Real