Hi, i am a bit confused on the real risk free rate. I am studying the estate planning material and the blue box example says to discount the expected spending needs by the real rfr which they show simply as nominal rfr - inflation. But then in the eoc questions another question that is basically the same shows the real rfr obtained by [(1+ nominal rfr) / (1+inflation rate) -1] which am i supposed to be using? Am I missing some obvious difference in these 2 questions? They produce very different answers.
Real = Nominal - Inflation
Only if inflation is high do they produce very different answers; if inflation’s reasonable they produce somewhat different answers.
The second is correct; the first is an approximation. I’d use the second, KentC’s advice notwithstanding.
Why do we do [(1+ nominal rfr) / (1+inflation rate) -1] to come up with the real rate and not just nominal-inflation rate?
Because interest rates and inflation compound.
1/(1+realint) = (1+ inflation)/(1+nominal rate)
Left hand side is discounting using real rate, right hand side discounts nominal amounts with nominal rates. Solve for realint and all will be revealed.