Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

Consider Figure 4.4. The bars plot the quarter-by-quarter annual rates of inflation for Australia from

1951 to 2015. The graph shows that inflation rates were high in 1980, at the same time that nominal

interest rates were high, as shown in Figure 4.3 (on page 132). Over the past two decades, as the

inflation rate gradually fell, so too did interest rates. Bonds are generally priced to offer a positive real

return, so nominal interest rates are high when inflation is high – as was the case around 1980 – and

rates are low when inflation is low.

expected Inflation and real Interest rates

Figures 4.3 and 4.4 clearly show a connection between interest rates and the inflation rate; but

the correlation is not 100%. For example, during the period 2000–2002, the Australian inflation rate

suddenly rose, then fell abruptly, while the nominal bond rate moved in a very limited range, mostly

downward. If inflation was very volatile during this period, why did interest rates not move directly in

concert?

There are at least two possible answers. First, when investors decide whether they want to purchase

a bond that offers a particular interest rate, what matters to them is not what the past inflation rate has

been, but rather what the inflation rate will be over the bond’s life. To determine whether the nominal

rate of return on a bond is high enough to provide a reasonable real return, investors must estimate how

much inflation they expect in the future. Even if inflation in the recent past has been fairly volatile, bond

yields may not move greatly if investors expect inflation to settle down (perhaps due to monetary policy

action to contain the inflation).

A reason that interest rates may change even when inflation remains unchanged is that the real

return required by investors may change. If the real rate falls while inflation (or expected inflation)

remains steady, bond yields will decrease. The real return required by investors may fluctuate with the

overall state of the economy as investors’ willingness to accept risk changes.

FIGUre 4.4 AUSTRALIAN INFLATION RATE

1956 1968 1980 1992 2004

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5

10

15

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25

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Source: Trading Economics. Used with permission. Trading Economics 2015, from http://www.tradingeconomics.com/