Certified Financial Management Specialist Practice Exam

What is defined as the interest rate on default-free securities without considering inflation?

1. Real Risk-Free Rate (R*)

2. Nominal Risk-Free Rate

3. Inflation Premium (IP)

4. Default Risk Premium (DRP)

The correct answer is: Real Risk-Free Rate (R*)

The definition regarding the interest rate on default-free securities without considering inflation directly points to the Real Risk-Free Rate (often denoted as R*). This rate reflects what investors would expect to earn on safe investments, such as U.S. Treasury bonds, in a scenario where there is no expectation of inflation. It serves as a baseline for evaluating the profitability of other investments after adjusting for inflation. The Real Risk-Free Rate is essential for understanding the fundamentals of finance, as it provides insight into the returns required by investors for taking on risk. Without accounting for inflation, this rate reflects the true return from an investment that has virtually no risk of default, allowing economists and financial analysts to understand the underlying economic conditions without the distortion caused by inflation. In contrast, the Nominal Risk-Free Rate includes inflation and represents the total return expected by an investor, thus leading to a different understanding of interest rates. The Inflation Premium is specifically defined as the component of the interest rate that compensates investors for expected inflation, which is not applicable when discussing a rate devoid of such considerations. Similarly, the Default Risk Premium pertains to compensation for additional risk taken over risk-free investments and is irrelevant to the concept of a default-free rate. Recognizing the correct definition in the context