--> By: Punam Sharma

• Normally when one speaks of interest rates, it refers to nominal interest rate which is not adjusted for inflation.
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• Inflation reduces value of money over a period of time. Therefore one needs to adjust for inflation to know the actual return on investment.
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• Interest rate adjusted for the effect of inflation is known as real interest rate.
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• Suppose one invests 100 in a 1 year bond having interest rate 8%. After a year return on investment is 108. This interest rate doesn’t adjust for inflation and is known as nominal interest rate.
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• Suppose one invests in same bond and assumes inflation for the year to be 6%, then the actual return on investment adjusting for inflation is 102. This 2% interest rate is known as real interest rate.
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Real Interest Rate = Nominal Interest Rate – Inflation

• As seen from the above formula, real interest rate is impacted by inflation.
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• Higher inflation lowers the real interest rate.
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• Nominal interest rate is determined by future expectation of inflation.
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• Real interest rate is impacted on how these expectations play out.
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• Assume nominal interest rate to be constant, real interest rate will decrease if inflation is higher than expectation and real interest rate will increase if inflation is below expectation1.
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• To understand how real interest rate is affected by inflation, we have assumed investment in a 10 year Gsec bond maturing in April 2016 with nominal interest rate of 7.40% p.a.2 .
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• Assuming we hold till maturity at the nominal interest rate of 7.40% p.a. and inflation3 changes every month, the real interest rate change can be observed in the chart below.
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• From the above chart, we can observe with high inflation real interest rate decreases and with falling inflation real interest rate increases.
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• During the years of very high inflation, real interest rates have been negative.
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• For the given period if one had invested minimum, average and maximum real interest rates are -3.85%, 0.52% and 8.11% respectively.
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• Chart below shows annual average 1-3 year fixed deposit rate, inflation (WPI) and real interest rates.
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Tag: By: Punam Sharma

• With effect from August 2005, non banks are not allowed to participate in call money market and to facilitate non banks participation in money market Collateralised Borrowing and Lending Obligation (CBLO) money market was created.
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• As the name suggests, in CBLO money market borrowing/lending takes place on collaterised basis.
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• CBLO was created and is operated by Clearing Corporation of India Ltd (CCIL).
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CBLO Money Market snap shot

• Chart below shows daily CBLO money market operations in terms of volume and weighted average rate from 1st January 2014 till 12th May 2014.
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• Chart below shows that in the overnight money market, CBLO has highest turnover followed by market repo reflecting higher trading in collateralised market segment.
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