year-end 2004, the Federal Reserve reported moderate
economic growth of 3%, a reduction
of the unemployment rate to 3% and an inflation rate
that was "well contained at 3%". Under
these circumstances, the real interest rate of the
10% corporate bond you own is 7% this year. Which
of the following economic factors would factor in
to the real interest rate of your bond?
a) Unemployment at 3%
b) The Fed Funds rate
c) Inflation at 3%
d) Economic growth at 3%
The correct answer is c).
The real interest rate, also referred to as the inflation-adjusted
return, factors the eroding effect of inflation from
an investment's return.
The formula is: Yield plus
or minus inflation rate = real interest rate/inflation-adjusted
The Fed Funds rate is the market rate that
banks charge each other on overnight loans of reserves.