Really though I would understand this by level III but I seem to find CONSTANT contradictory information.

Nominal Rate = 8%

Inflation = 3%

Then real rate = 5%

i.e. the nominal rate includes/reflects inflation.

Please explain this quote!!:

All liabilities subject to inflationary effects should be matched with real-rate bonds, i.e., bonds with yields that reflect risk premium and inflation.

Do nominal bonds not refelct inflation? How/why? If I need a return of 5% indexed to inflation and inflation is 3%, wouldn’t I want a nominal rate bond at 8%?

To clarify, 8% nominal, 3% expected inflation would equal a real rate of 5%. But that real rate includes actual inflation? Still confused…TIPS + expected inflation equals nominal???

To add further clarification:

James has a 1,000,000 portfolio and needs $2,000,000 in 10 years. What is the nominal rate needed? What is the real rate needed? Inflation is 1%.

The Required RoR is 7.18%, and the CFAI calls it “Nominal”. However, that includes a premium for expected inflation? How? I would expect you would need 8.18% nominal (ror + inflation). If inflation was 1000% and you received a 7.18% return, how would you have $2MM?

The TIPS principal is adjusted by actual inflation, not expected inflation.

As for James, if the $2,000,000 he needs in 10 years is in then-year dollars, then 7.18% is a nominal return: 6.18% real return, 1% inflation. If the $1,000,000 he needs in 10 years is in current-year dollars, then 7.18% is the real return and 8.18% is the nominal return. It all depends on what “$2,000,000” means.

Nominal bonds do not reflect actual inflation. If your liabilities increase at the rate of inflation, (lets say 2%) and you’re receiving a nominal return of 8% (6% real return) on your assets, you’re doing pretty good. However, if inflation increases to 8%, you’re now receiving a real return of 0% if your nominal return is still 8%, this is bad.