Nominal and Real Returns

One of the primary functions of the Federal Reserve Bank is to control the money supply. When the money supply is increased or decreased, it affects the market interest rate. In order to stimulate the economy, the Fed may increase money supply through open market operations (buying and selling government bonds), decreasing the required reserve ratio (amount of reserves banks are required to hold) or lowering the discount rate (interest rate charged to banks). Increasing the money supply causes the interest rate to fall, which will lead to more investment and spending (increasing the Aggregate Demand of the economy). Sometimes when there is excess aggregate demand, it leads to inflation in the economy. In this SLP assignment, we will examine how inflation affects the value of money using the stock market application. This lesson will examine the historical pricing of your selected stock to give you an idea of how your investment may work for you. By going back five years in pricing history, this lesson reinforces the importance of being a long term investor. You will see that it is relatively easy to recognize the change in the stock's price over time. But this lesson goes further and you will examine some factors that deplete returns. You will find that actual returns can be reduced by inflation, transaction costs, and taxes. It is similar to your take-home-pay not being what you had hoped it would be! 1) Use the Internet site to chart the price history of the company they selected over the past five years. You should go to Historical Quotes can be found here: http://finance(dot)yahoo(dot)com/q/cp?s=^DJI You can simply look at the purchase price in each year from 2006 and the selling price today in 2010. It is better to sort your historical stocks by clicking “monthly.” When you open the stock history table, you should use the column labeled "Adjusted Close." This will adjust the price for dividends and splits. After finding the stock price in each year, present your results in a table such as the following: Historical Quotes of Apple Inc. Stock (not a DOW 30 stock). A chart is optional. Year Price Feb-06 68.49 Feb-07 84.61 Feb-08 125.02 Feb-09 89.31 Feb-10 201.67 2) Now use the information from the price history to calculate the nominal and real rate of return.[Nominal refers to the actual dollar price of stuff when it's bought or sold. The contrast is with the term real, which is actual value adjusted for inflation.] You need to calculate the returns only for 2006 and 2010. To Calculate Nominal Return using Apple (stock symbol is AAPL). In 2006, suppose you invested $1000 in Apple stock. You would have $1000/$68.49 = 14.60 shares of stock with a nominal value of $1000. Assume no brokerage fee. In 2010, the nominal return on your Apple stock is 14.60 shares * current price of $201.67 = a nominal total return of $2,944.51. To calculate the nominal rate of return, simply take a percentage change: (2,944.51 - 1000)/1000 = 1.94 * 100 = 194% (we should have bought Apple stock!) The real rate of return adjusts the nominal rate of return for inflation. Therefore if we assume the inflation rate is 3% per year, we get the following: real rate of return = nominal rate of return - inflation real rate of return = 194% - (3% * 5 years) = 194% - 15% = 179% (still not too bad) The case of Apple Inc. can be extreme. For instance, if you invested in a stock with a 12% nominal rate of return, then the real rate of return after 5 years would actually be -3%! In this case, it would have been better to keep our money in a bank. Try this with your selected stock and write a summary comparison of the results. 3) On February 18, 2010 the Fed announced that they would increase the discount rate (rate at which banks borrow reserves) after one year of extraordinary lows. Think about the industry your selected stock is in. How do increased interest rates affect the price of your stock? Explain. SLP Assignment Expectations: Use concepts from the modular background readings as well as any good quality resources you can find from the cyberlibrary or other internet search engines. Please be sure to cite all sources within the text and a reference list at the end of the paper. Length: 2-3 pages double spaced and typed The following items will be assessed in particular: Your ability to explain the differences between nominal and real variables.