Fisher Equation VS. Nominal Risk Free Rate

CFA Level I
#1

Hi,

There seems to be a conflict between economic theory and finance calculation of nominal risk free rate.

NRFR = (1 + RRFR)(1 + inflation) - 1

whereas Fisher Effect in macroeconomics state it is a simple addition

NRFR = RRFR + Inflation Does anyone know the mathematical or logical reasoning behind it? The difference is marginal at best, but what’s the logic in compounding inflation with RRFR?

It would make more sense to use simple addition considering both inflation and RRFR occur concurrently from year start to year end and do not happen year on year (so no reason to compound).

#2

No conflict, the economics equation is an approximation. The terms Rrfr and Infl are very small, 0.something. Their product is way way smaller, so close to 0. So as an approximation, it can be ignored.

#3

Thanks!