## The Fisher Effect

Our discussion of real and nominal returns illustrates a relationship often called the Fisher effect (after the great economist Irving Fisher). Because investors are ultimately concerned with what they can buy with their money, they require compensation for inflation. Let R stand for the nominal rate and r stand for the real rate. The Fisher effect tells us that the relationship between nominal rates, real rates, and inflation can be written as:

Fisher effect

The relationship between nominal returns, real returns, and inflation.

where h is the inflation rate.

In the preceding example, the nominal rate was 15.50 percent and the inflation rate was 5 percent. What was the real rate? We can determine it by plugging in these numbers:

1 + .1550 = (1 + r) X (1 + .05) 1 + r = 1.1550/1.05 = 1.10

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

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