Numbers every analyst uses
Inflation and real returns
Separate how many riyals you have from what they can buy: convert between nominal and real rates with the Fisher relationship, and value cash flows consistently.
Learning objectives
- Explain the difference between nominal and real amounts and returns
- Convert between nominal and real rates with the exact Fisher relationship, and know when the shortcut fails
- Restate future amounts in today's purchasing power with a price index
- Discount cash flows consistently: nominal with nominal, real with real
A deposit that grows from 10,000 to 10,500 riyals has earned 5%. But if prices rose 2.5% over the same year, the 10,500 buys only what 10,244 bought a year ago. The first figure is a nominal return, counted in riyals; the second is a real return, counted in what those riyals can buy.
Real returns are what savers, pension planners and employees actually care about. Analysts need both, and must never mix them: a forecast in nominal riyals has to be discounted at a nominal rate, and a forecast in today's prices at a real one.
(1 + n) = (1 + r) × (1 + i) ⇒ r = (1 + n) ÷ (1 + i) − 1 and n = (1 + r) × (1 + i) − 1
- n
- nominal rate: growth in the number of riyals
- r
- real rate: growth in purchasing power
- i
- inflation rate over the same period
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That's the last lesson in Finance Fundamentals
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