This may be a silly question. For exam FM we learn that the real interest rate, r, is defined as (1+r) = (1+i)/(1+q), where i is interest and q is inflation. And we learn that a decent approximation of r is i-q.
To me the idea of a real rate of return is that after applying a certain growth rate and applying a certain decay rate, it is the "true", or "net" growth rate.
In contrast, an interest rate spread is the difference between two interest rates. If I can earn 7% on $100 and I am obligated to credit 4% to someone else, I literally take in $7 then $4 goes out the door. It is a net 3% gain.
To me the net interest rate seems more like what I would call the "real" rate of return. Why not just subtract the inflation rate from the interest rate like we do in the approximation? Conceptually, why the relationship (1+r) = (1+i)/(1+q)?
Another way to state this - in both the real interest rate and net interest rate scenarios, we have competing rates. One formula takes the ratio of (1+rate1)/(1+rate2) = (1+ overall effective rate), while the other does rate1 - rate2 = overall effective rate. Why is one multiplicative, and one is additive?
To me the idea of a real rate of return is that after applying a certain growth rate and applying a certain decay rate, it is the "true", or "net" growth rate.
In contrast, an interest rate spread is the difference between two interest rates. If I can earn 7% on $100 and I am obligated to credit 4% to someone else, I literally take in $7 then $4 goes out the door. It is a net 3% gain.
To me the net interest rate seems more like what I would call the "real" rate of return. Why not just subtract the inflation rate from the interest rate like we do in the approximation? Conceptually, why the relationship (1+r) = (1+i)/(1+q)?
Another way to state this - in both the real interest rate and net interest rate scenarios, we have competing rates. One formula takes the ratio of (1+rate1)/(1+rate2) = (1+ overall effective rate), while the other does rate1 - rate2 = overall effective rate. Why is one multiplicative, and one is additive?
Real interest rate vs. net interest rate
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