In last year’s CFA institute mock exam, there was a question about likely effect of unexpected increase in inlation rate. Can anyone explain why unexpected increase in inflation rate will decrease profitability of an investment? Does it have anything to do with the value of depreciation tax shield? Thanks
because the real returns will be lower…
You had estimated the inflation to be 3% next year, but it turns out to be 15% and all your estimates of returns/profitability have gone wrong and are understated. Since the $$ you get when the inflation is 15% will hold less value (buy less things) than what they would have been worth when the inflation was a mere 5%.
Expected returns have a built in expectation of inflation. E®=1.real returns*1.inflation When inflation is higher than expected you lose becuase you dollar value didn’t hold its value the way it would have if inflation was at expected levels.