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Negative real yields

0 votes
asked Aug 19, 2018 in BUS 4027W - Actuarial Risk Management by anonymous

BUS4027W Test 3.pdf (0,9 MB)

With regard to Q2 (iii): Reasons why there could be a negative real returns.

The reasons outlined in the memo make sense. However, I anticipated the main reason one would achieve negative real returns is due to inflation being higher than expected, after all, we have the following equation:

Nominal yield= Risk-free real yield + Expectations of future inflation + Inflation risk premium

From the above equation, it would seem that real yields would only be negative if the inflation exceeded the nominal yield. It seems the memo only considers demand factors causing yields to be negative. 

1 Answer

0 votes
answered Aug 22, 2018 by ErichMaritz (500 points)

Note that the question asks about real yields, not real returns. So we are forward-looking.

Also, the equation in your question is forward-looking, trying to explain the relationship between nominal bond yields and ILB yields. 

The achieved real return on a nominal bond can indeed be negative if inflation is higher than expected. If held to maturity, then

Real return on bond = Purchase yield on nominal bond - actual inflation.