Certified Financial Management Specialist Practice Exam

The term 'nominal risk-free rate' includes which of the following?

1. Only real returns

2. Returns plus expected inflation

3. Returns without inflation considerations

4. Only the inflation premium

The correct answer is: Returns plus expected inflation

The term 'nominal risk-free rate' is defined as the return on an investment that is considered completely free of risk, typically represented by government securities like Treasury bills. This rate includes not only the real rate of return but also an allowance for expected inflation. By incorporating expected inflation, the nominal risk-free rate reflects the actual purchasing power of money over time. As inflation rises, the nominal rate must also increase to maintain the same real return. Therefore, the nominal risk-free rate is formulated as the sum of the real return on an investment and the expected inflation rate, which aligns perfectly with the selected choice. Other options miss key components of what constitutes the nominal risk-free rate. For instance, the option referring to 'only real returns' overlooks the necessary adjustment for inflation, while 'returns without inflation considerations' entirely disregards the impact of inflation on real purchasing power. Lastly, 'only the inflation premium' ignores the baseline real return that is also a critical part of the nominal rate's calculation. Thus, the correct understanding underscores that the nominal risk-free rate comprehensively encompasses both returns and expected inflation.