nominal, real etc etc

Hoping you can help clarify something for me.

When we are calculating the nominal return for a IPS question, we add the inflation component. However when we are assigning asset allocation to a pension fund, we assign nominal bonds to asset not linked to inflation…

I’m struggling to understand the logic…

Why do we does nominal = real + inflation, but we use nominal bonds when there is NO inflation indexation in a pension plan?


S2000 can confirm if what I am saying is true.

Nominal Rate = Real Rate + inflation -> what we do on the IPS questions.

Pension fund - liability mimicking asset portion

Nominal Bond -> Pays the “assigned” rate of interest (coupon) on the bond.

Real Bond -> pays the assigned real rate of interest (coupon) on the bond + pays the inflation index component as well.

Thanks for your response.

TIPS are real rate bonds and offer coup + inflation. In the liability mimicking instance a real rate bond implies that the inflation component is already incorporated into the returns. However when we do an IPS question the real rate is without inflation…

I dont see why they are different.

you are interested in the REAL RATE for IPS, REAL RATE Bond for the Mimicking part.

The REAL RATE - does not include inflation. The real rate BOND does include inflation.

I’m also curious.

Financial instrument: Real means included inflation

Return: Real means excluded inflation

Interesting …

Nominal _ always _ means that inflation is included, and real _ always _ meas that inflation is not included.

The confusion is in the misunderstanding of how those terms are applied to bonds: they describe the bonds’ coupon rates.

To describe a bond as nominal means that its coupon rate includes a premium for (expected) inflation.

To describe a bond as real means that _ its coupon rate does not include a premium for inflation _; inflation is handled in the face value of the bond.