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CA1-Dist rate in solution36.2

M

m_bora

Member
In this question the liability cashflows are nominal while discount rate used is real yield.. can you explian why?
 
Hi

Remember that benefits from the XYZ scheme increase each year at the market rate of inflation (ie 3.5%). So the solution to 36.2(ii) can be viewed in a couple of ways;

1. The real annual benefit is actually $125,000 (even though in nominal terms it increases with inflation), and so the $125,000 should be discounted at the real rate.

2. Calculate the nominal cashflows by increasing the $125,000 benefit by 3.5% per annum, and then discount at the nominal rate (ie 5%).

Either way the resultant discount rate to be used in the annuity factor is 1.45% pa.
 
Actually 5% rate must be the real rate, as it is given to be the GRY on the index linked bond.
In that case, we must just discount $125,000 by 5% (option 1 as you mentioned).
Correct?
 
Last edited by a moderator:
Yes, I see what you mean. The intention was that the 5% should have been used as a nominal yield (for consistency with the other approaches) but this could have been made clearer from the question.

I'll make sure that this is updated in the next edition of the Course Notes.

Thanks
 
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