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This pathway will walk us through the basics of banks, starting with some of the different types and their main functions, then starting to look at the regulation faced by the banks, both before and after the Global Financial Crisis.

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In this video, Max discusses the cost-of-living crisis currently enveloping the UK. He examines its impact on households as well as the overall economy.

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In the first video of this two-part video series, Elisa introduces us to sustainability. She begins by looking at the difference between sustainability and corporate social responsibility, two terms that can be easily confused.

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Calculating Real Returns

Calculating Real Returns

Abdulla Javeri

30 years: Financial markets trader

Chances are when someone quotes a figure for investment returns it’s likely to be on a nominal or gross basis, without taking into account the effects of inflation. Purchasing power only increases if returns outstrip inflation over a given period. Abdulla addresses this fact and explains how to measure real returns for a single period, and over time, to help us understand inflation-adjusted returns.

Chances are when someone quotes a figure for investment returns it’s likely to be on a nominal or gross basis, without taking into account the effects of inflation. Purchasing power only increases if returns outstrip inflation over a given period. Abdulla addresses this fact and explains how to measure real returns for a single period, and over time, to help us understand inflation-adjusted returns.

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Calculating Real Returns

4 mins 42 secs

Key learning objectives:

  • Identify the two methods in calculating real returns

  • Use the calculation to determine if wealth has increased or decreased

Overview:

Real returns are in other words, inflation adjusted returns. Over the long-term, it’s important to consider the impact of inflation on returns to determine if we are wealthier. We increase our purchasing power or wealth, if our returns outstrip inflation over a given period.

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Summary

What are the two methods of calculating real returns?

  1. Fisher Effect Equation: Nominal rate - Inflation Rate. However, this disregards the effect of time
  2. Real Rate = (1+ Nominal rate) / (1+ Inflation rate) - 1

Real returns impact which parties?

Real returns are good for savers and investors. However, if you’re a borrower, you would prefer negative real rates, because it means you’re paying back devalued money.

Using the information in the table, how do we calculate the inflation index, inflation rate, fisher, real rates and investment?

Years Inflation Index Nominal Rates/Returns Inflation Rate Fisher Real Rates Investment
0 100.00 100.00
1 102.00 5.00% 2.00% 3.00% 2.94% 105.00
2 104.50 3.00% 2.45% 0.55% 0.54% 108.15
3 107.00 6.00% 2.39% 3.61% 3.52% 114.64
4 109.20 2.00% 2.06% -0.06% -0.05% 116.93
5 113.00 7.00% 3.48% 3.52% 3.40% 125.12
  1. Inflation Rate
    • Year 1: (102/100) -1 = 2%
    • Year 2: (104.5/102) -1 = 2.45%
  2. Fisher: (Nominal rate - Inflation rate)
    • Year 1: (5% - 3%) = 2%
    • Year 2: (3%-2.45%) = 0.55%
  3. Real Rate
    • Year 1: (1+ 0.05) / (1 + 0.02) - 1 = 2.94%
    • Year 2: (1+0.03) / (1+ 0.0245) - 1 = 0.54%
  4. Investment
    • Year 1: 100 x (1+0.05) = 105
    • Year 2: 105 x (1+ 0.03) = 108.15

Have we increased our wealth over this 5-year period?

  • Nominal Return (5Yrs): (125.12/100) - 1 = 25.12%
  • Inflation (5Yrs): (113.00/100.00) - 1 = 13%
  • Annualised 5-Year Real Return: (1+0.2512) / (1+ 0.13) -1 = 2.0581%

Given those returns and those inflation rates, we have increased our wealth, on average, by 2.0581% above inflation.

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Abdulla Javeri

Abdulla Javeri

Abdulla’s career in the financial markets started in 1990 when he entered the trading floor of the London International Financial Futures Exchange, LIFFE, and qualified as a pit trader in equity and equity index options. In 1996, Abdulla became a trainer for regulatory qualifications and then for non-exam courses, primarily covering all major financial products.

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