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Sir, no mention of this topic in lecture video chapter 22 (Forecasting Foreign Currency Exc Rates)
Tell me what is it and its importance for the coming exam 🙂
Thank you sir!
It is not mentioned in that lecture because it is not relevant to forecasting foreign exchange rates!
In theory, interest rates and inflation rates will move up and down together – that is what the formula is showing.
The relevance is in investment appraisal. We need to discount the nominal (actual ) cash flows at the nominal (actual) cost of capital. Sometimes, instead of giving you the nominal cost of capital, you are given the real cost of capital (i.e. the cost of capital without inflation). In that case you use the Fisher formula to calculated the nominal cost of capital.
(1 + i) = (1 + r) x (1 + h), when i is the nominal cost of capital, r is the real cost of capital, and h is the general rate of inflation.
(I deal with this at the end of the investment appraisal lecture, although I use different symbols – I must update the symbols (it is because he only started giving the formula recently, Before you needed to learn it 🙂 )
SIR,
AM CO WILL RECEIVE A PERPETUITY STARTING IN 2 YEARS TIME OF 10,000 PER ANNUM,INCREASING BY THE RATE OF INFLATION 2%.WHAT IS THE PERPETUITY ASSUMING A MONEY COST OF CAPITAL OF 10.2%?
MY QUESTION IS WHY THEY USED REAL COST OF CAPITAL IN THE ANSWER?
Please do not type in capital letters.
I assume that you have watched the lectures and therefore you know that we can either inflate the cash flows and then discount at the nominal cost of capital (which is what we usually do) or we can discount the real cash flows at the real cost of capital.
Obviously it is impossible to do it the normal way when it is a perpetuity.
So we have no choice but to do it the second way – use the real cash flows (i.e. ignoring inflation) and discount at the real cost of capital.(And who are ‘they’? Could ‘they’ not have given the reason? 🙂 )
but my question is why we cannot do it in nominal cash flow while it is in perpetuity….and if it is then why in Kaplan book they used nominal rate…
The nominal cash flows are the actual cash flows (after inflating).
So the cash flow in 2 years time is 10,000x(1.02)^2
In three years time it is 10,000x(1.02)^3
and so on
You would need a very long piece of paper if you were to continue doing this in perpetuity!!!Kaplan have NOT used the nominal rate. You said yourself in your previous post that they have used the real rate. The nominal rate is the actual cost of capital; the real rate is the cost of capital with the inflation effect removed.
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