Real and Nominal

CFA Level III
#1

I know this seems simple but I always confuse real and nominal, even to this day sitting at level 3. I get it, nominal equals the real rate plus the inflation rate, simple enough. Where I am confused is within institutional wealth management.

In institutional wealth management they assign assets that are appropriate for different types of db plan participants. Where I’m confused is that the text says plan beneficiaries whose future benefits are linked to inflation should have real rate bonds attached to their liability, while those that have a fixed level of future payments not subject to inflation should have nominal bonds attached to their liability. Why is this? If nominal is real + inflation then why shouldn’t nominal bonds be linked to plan participants that could be subject to inflation?

#2

nominal rate = real rate + inflation rate.

When you talk returns - they are on the denominator … so things are inverted (bcos you always use the return on a bond in the denominator to calculate the present value of the Bond).

A nominal bond will only return what it promises. A real bond will return both what it promises + compensate you for the inflation rate.

i do not know if this helps, but if it helps set things straight – go ahead and use it.

#3

expected inflation rate

you don’t know what the actual inflation rate will be, so you hedge that.

#4

This may be unorthodox and not academically sound, but the way I think of it is nominal = fixed rate bond; real = floating rate bond.

Thinking back to the swap calcs from level 2, the fixed rate is determined at the beginning but the floating rate resets to par at each reset period. The “real” rate can be thought of as the spread above LIBOR, and the inflation can be thought of as LIBOR. Regardless of what LIBOR does, you’re guaranteed to earn the spread.

So if your nominal bonds pay a 7% coupon, real bonds pay a 3% spread over LIBOR (inflation), and inflation all of a sudden shoots up to 5%, you’re left with much less purchasing power on your nominal bonds (7 - 5 = 2%); whereas your real bonds reset and now pay you 5 + 3 = 8%.

The real bonds virtually ignore whatever inflation does because they “float” with it. Not sure if this helps, but it somehow resignates in my brain.

#5

Nominal bonds hedge expected inflation, real bonds hedge actual inflation as it occurs.

#6

Better is:

  • Nominal = straight, fixed-rate bond
  • Real = TIPS