10/1/23, 12:37 AM The risk-free rate is 3.4 %,and expected inflation is 1 %.

n is 1 %. If inflation expectations change such that future expected inflation rises t…

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Capital asset pricing model (/learn/capital-asset-
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The risk-free rate is 3.4 %,and expected

inflation is 1 %. If inflation expectations
change such...

Question:
The risk-free rate is 3.4 %,and expected inflation is 1 %. If inflation expectations change such
that future expected inflation rises to 4.8 %, what will the new risk-free rate be?

The Risk-free Rate:

The risk-free rate of return is an interest rate on security or a debt instrument that has no risk.
Generally, all investments carry some risk and therefore, the risk-free rate is just a hypothetical
or a theoretical rate.

 Answer and Explanation:

The real risk-free rate is calculated as:

Nominal risk rate + 1
Real risk f ree rate = [ ] − 1
Inf lation rate + 1

In our question, we have:

Nominal risk free rate = 0.034
Expected inflation = 0.01

Therefore:
0.034 + 1
Real risk f ree rate = [ ] − 1
0.01 + 1

Real risk f ree rate = 1.024 − 1 = 0.024

If the inflation is expected to rise to 4.8% in the future, the new nominal risk-free rate will be
equal to:

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10/1/23, 12:37 AM The risk-free rate is 3.4 %,and expected inflation is 1 %. If inflation expectations change such that future expected inflation rises t…

Nominal risk rate + 1

0.024 = [ ]
0.048 + 1

1.048(0.024 + 1) = Nominal risk rate + 1

1.073 = Nominal risk rate + 1

Nominal risk rate = 1.073 − 1 = 0.073 = 7.3%

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Capital Asset Pricing Model (CAPM): Definition,
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