Which of the following is an inflation-adjusted return?
(A) Annual percentage yield (APY)
(B) Liquidity yield
(C) Real rate of return
(D) Nominal rate of return
The correct answer and explanation is :
The correct answer is (C) Real rate of return.
Explanation:
Inflation-adjusted returns are designed to account for the effects of inflation on the purchasing power of money over time. The real rate of return is the measure of the return on an investment after accounting for inflation, reflecting the actual increase in purchasing power. This provides a more accurate picture of an investment’s performance because it factors in how inflation erodes the value of money.
Here’s why the real rate of return is the correct answer:
- Real rate of return:
- The real rate of return is the nominal return on an investment adjusted for inflation. It gives a clearer picture of the actual profitability of an investment, as it accounts for the loss in purchasing power due to inflation.
- For example, if you earn a 6% return on an investment but inflation is 2%, your real rate of return would be approximately 4%. This means your actual gain in purchasing power is only 4%, not 6%. The formula to calculate the real rate of return is:
[
\text{Real Rate of Return} = \frac{1 + \text{Nominal Rate}}{1 + \text{Inflation Rate}} – 1
]
This formula adjusts the nominal rate for inflation, ensuring that the return reflects true growth in purchasing power.
Why the other options are incorrect:
- (A) Annual percentage yield (APY): APY measures the yearly return on an investment, factoring in compound interest. It does not account for inflation, so it is not an inflation-adjusted return.
- (B) Liquidity yield: Liquidity yield is a measure of the return on an investment in relation to its liquidity. It does not take inflation into account and is unrelated to inflation-adjusted returns.
- (D) Nominal rate of return: The nominal rate of return is the percentage gain or loss on an investment without considering inflation. This measure reflects the raw return but ignores the erosion of purchasing power due to inflation.
In conclusion, real rate of return is the only option among the listed choices that provides an inflation-adjusted return.