Question

Saladin is willing to lend her friend Astro $500 to buy a new smart phone. Saladin wants a 3% real rate of return on the loan when it is paid back at the end of the year. She believes that during the year the general level of prices will rise by 2%, so she should charge her friend Astro a nominal interest rate of:_______.

a. ​5%.
b. 4%
c. 3%.
d. ​2%.

Answer 1

Nominal interest rate is 5%

Step-by-step explanation:

Nominal interest rate is the rate of return that is made up of real rate and inflation rate i.e 3%+2%=5%

In charging the nominal interest rate , the lender assumes that other risks that should also be compensated for , do not apply to the transaction at hand.

The other risks that the lender might also want to consider apart from inflation risk are itemized below:

Liquidity risk

Maturity risk

Default risk

Liquidity risk is the potential loss that could arise from forced sale of investment for liquidity preferences- needs for urgent cash.The proceeds derivable from sale such is usually lower than the bond fair value,hence the difference is due to liquidity risk that should be compensated

Maturity risk requires that the investor be paid maturity risk premium to cover for the sensitivity of bond value to changes in interest rates.

Default risk is the risk that the borrower may fail to make available to the lender the contracted cash flow at the contracted time .

Answer 2

a. ​5%.

Step-by-step explanation:

If Saladin is willing to lend her friend Astro $500 to buy a new smart phone. and wants a 3% real rate of return on the loan when it is paid back at the end of the year. If she believes that during the year the general level of prices will rise by 2%, so she should charge her friend Astro a nominal interest rate of ​5%.

The reason is that inflation depletes the value of returns received by lenders because of the reduction in the purchasing power of money. The nominal rate in order to return a real rate of is that which has been adjusted for inflation.

Therefore Nominal Rate = Rate of required return 3% + Inflation rate 2% = 5%