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Real versus Nominal Risk free Rates

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Under conditions of high and unstable inflation, valuation is often done in real terms. Effectively, this means that cash flows are estimated using real growth rates and without allowing for the growth that comes from price inflation.

To be consistent, the discount rates used in these cases have to be real discount rates. To get a real expected rate of return, we need to start with a real risk free rate. While government bills and bonds offer returns that are risk free in nominal terms, they are not risk free in real terms, since expected inflation can be volatile.

The standard approach of subtracting an expected inflation rate from the nominal interest rate to arrive at a real risk free rate provides at best an estimate of the real risk free rate. Until recently, there were few traded default-free securities that could be used to estimate real risk free rates; but the introduction of inflation-indexed treasuries has filled this void.
An inflation-indexed treasury security does not offer a guaranteed nominal return to buyers, but instead provides a guaranteed real return. Thus, an inflation-indexed treasury that offers a 3% real return, will yield approximately 7% in nominal terms if inflation is 4% and only 5% in nominal terms if inflation is only 2%.

The real risk free rates in markets where governments do not issue index-linked bonds can be estimated by using one of two arguments.
The first argument is that as long as capital can flow freely to those economies with the highest real returns, there can be no differences in real risk free rates across markets. Using this argument, the real risk free rate for a market with index-linked government bonds, for example the UK, can be used as the real risk free rate in any market.
The second argument applies if there are frictions and constraints in capital flowing across markets. In that case, the expected real return on an economy, in the long term, should be equal to the expected real growth rate, again in the long term, of that economy, for equilibrium. Thus, the real risk free rate for a mature economy like Germany should be much lower than the real risk free rate for an economy with greater growth potential, such as Hungary.

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