Overview
The market rate of return is the interest rate that the market demands for lending money. It is the result of the forces of supply and demand which play out in the market for money. (see LM Curve for a macroeconomic description of the demand for money)
In reality, there are several different interest rates, one for each time frame, or maturity, for which the money is being lent. This gives rise to an interest rate curve.
Please see fixed income analysis for a more in depth look at the analysis of interest rates and fixed income securities.
Real vs Nominal Rates
Securities that promise a rate of return, specify that rate of return in terms of the nominal interest rate. That is, the rate is specified solely in terms of dollars amounts, without taking into account changes in prices. (inflation)
The real interest rate is defined to be the rate of return minus the expected rate of inflation.
{% r = r_{real} + \pi_{ex} %}
where
- {% r %} - nominal interest rate
- {% r_{real} %} - the real rate of return
- {% \pi_{ex} %} - the expected inflation rate
The interest rate that uses the actual rate of inflation (instead of the expected rate) and calculated after the fact is referred to as the ex-post real interest rate.
Economic theory suggest that when investors decide which instruments to invest it, they are focused on real rates of return, and not nominal rates. (that is, they care more about actual purchasing power, as opposed to dollar amounts)