| By SYDNEY CASELY-HAYFORD, Business in Ghana With notes from WIKIPEDIA In economics and finance, an individual who lends money for repayment at a later point in time expects to be compensated for the time value of money, or not having the use of that money while it is lent. In addition, they will want to be compensated for the risks of having less purchasing power when the loan is repaid. These risks are systematic risks, regulatory risks and inflation risks. The first includes the possibility that the borrower will default or be unable to pay on the originally agreed upon terms, or that collateral backing the loan will prove to be less valuable than estimated. The second includes taxation and changes in the law, which would prevent the lender from collecting on a loan or having to pay more in taxes on the amount repaid than originally estimated. The third takes into account that the money repaid may not have as much buying power from the perspective of the lender as the money originally lent, that is inflation, and may include fluctuations in the value of the currencies involved. Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money. Real rates = Nominal rates minus Inflation and Currency adjustment. The "real interest rate" in an economy is often the rate of return on a risk free investment, such as GoG Treasury bills, minus an index of inflation, such as the CPI, or GDP deflator. For example, if somebody lends Ghc10,000 for a year at 10 percent, and receives GHc11,000 back at the end of the year, this represents a 10 percent increase in purchasing power if prices for the average goods and services bought are unchanged from what they were at the beginning of the year. However, if the prices of the food, clothing, housing, and other things purchased have increased 13.3 percent over this period, there is in fact a real loss of about 3.3 percent in purchasing power. The inflation rate is not known in advance. People often base their expectation of future inflation on an average of inflation rates in the past, but this gives rise to errors. The real interest rate ex post may turn out to be quite different from the real interest rate that was expected in advance. Borrowers hope to repay in cheaper money in the future, while lenders hope to collect on more expensive money. When inflation and currency risks are underestimated by lenders, they suffer a net reduction in buying power. Banks therefore will take a less risky position and overestimate the risks, thus charging higher interest rates for their lending. The expected real interest rate can vary considerably from year to year. The real interest rate on short-term loans is strongly influenced by the monetary policy of the central bank. Related is the concept of "risk return", which is the rate of return minus the risks as measured against the safest (least-risky) investment available. Thus if bank loans are made at 28.5% with an inflation rate of 13.32% and a certain amount of risk is associated with default or problems repaying (say 10.0%) then the "risk adjusted" rate of return on the investment is 6.18%. (28.5-13.32-10)
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