Can someone intuitevely explain this?! Every question I try and answer is phrased differently… i.e. question 2 in reading 8 of the EOC. I get i’m suppse to add inflation when to maintain purchasing power on top of the return that needs to be generated, but HOW CAN I GET THIS RIGHT EVERY TIME WITH THE LITTLE TRICKS THE CFA USES TO CONFUSE PEOPLE! Please help. thanks!
Hi,
I agree that it is annoying to have to guess what return is the target variable…
In Q2 R8 EOC, from my understanding, there are two possible " return requirements"
One could work with the “nominal return requirement” which, in this example is 50/1120+inflation = 7.46% and compare that “nominal return requirement” with the "expected portfolio return " of 82.5/1120=7.4%
They worked instead with the “real return requirement” of 50/1120=4.46% and compare that to the “expected real return” = "expected portfolio return " -inflation =4.4%
If there is no precision in the question of the AM exam, i will simply explain clearly in my answer what is my target.
From what i have seen in previous AM exam (did not do a lot yet) , it is clearly stated :
For example, I highly recommand doing Q1 of AM 2013 exam in two different ways and then look at the answer.
“Determine the Voorts’ nominal after-tax required rate of return for the coming year.”
First method,
Estimate how much return do you need to keep the purchasing power of the investment portfolio (11M)
Since inflation is 2.5%, you need to gain 275K
On top of that, you need to cover inflated expense for next year ( minus after tax income) = 220K
=> nominal return need to be (220+275)/11000 = 4.5%
Second method
Forget about keeping the purchasing power of the investment portfolio
Just calculate the return you need to cover inflated expense = 220/11000 =2%
Then use the Equation Real Return = Nominal Return - Inflation
=> Nominal return = Real return + Inflation = 2 +2.5=4.5%
Hope that helps.
Thanks for your response
The thing that is confusing to me is that if inflation averages 3% annually, i would assume that the portfolio needs to be increased by an 3% in order to keep up with the increase in christa’s expenses. therefore i would assume that the return requirement is already in "real"terms.
Example:
Christa’s expenses = $82.5
Investment portfolio = $1,120
Return Requirement = 82.5/1120 = 7.4% (rounded)
Inflation is expected to be 3% per the question
Expenses increased by inflation = 82.5 * (1.03) = 85 (rounded)
In order to maintain her purchasing power (i.e. maintain a return that is sufficient enough to keep up with the actual REAL expense)
The portfolio needs to increase by the rate of inflation so therefore we have
(82.5*1.03) / (1,120*1.03) = 7.4% THIS IS THE REAL RETURN the inflation return is 3% and cancels out in order to maintain her purchasing power, you still have the same amount of expenses.
My conclusion, based on this logic is that the return requirement was already in real terms and in order to keep up with inflation it needs an inflation component of 3% added.
THE QUESTION DOESNT SAY LAST YEARS EXPENSES IT SAYS THIS YEARS EXPENSES (NO INDICATION THAT INFLATION WAS IN IT)… it is very confusing and i feel not worded appropriately to understand unless I just don’t understand it.
Are you going to add additional inflation to something that you spent in THIS YEAR???