Real versus Nominal rate of return

CFA Level III Portfolio Management
#1

Hi All,

I have question on reading 8 (page # 202, Question 2). In this problem, it is determined whether Christa’s anticipated return is sufficient to cover her required expenses if she combines her studio and apartment to save EUR 32,000

Her income from art sale is 50,000 and if she combines studio and apartment her expenses would be 100,000 which means she needs her portfolio to generate remaining 50,000. so required return is 50,000/1,120,000 = 4.5%

Her anticipated return from portfolio is 82,500, which translates to return of 7.4%

Reading has taken4.5% as real return. I understood this as we have to incorporate inflation to get nominal rate of return. I do not understand why 7.4% is considered as nominal? where is the consideration of inflation in calculating this rate?

Thanks!!

#2

7.4% is the actual performance she expects to achieve. So ideally that $82.5k is going to pay for:

  • Her expenses of $50k
  • Growth in her assets to neutralize the effect of inflation

4.5% is what she calculates she will need to earn to pay for:

  • Her expenses of $50k

So, the required return value of 4.5% does not account for the effect of inflation. Therefore, it’s the real (~purchasing power) required return.

Adding 3% inflation to 4.5% real required return = nominal required return of 7.5%, which her actual return can’t meet (by a hair).

#3

Thanks biuku for the explanation!