Continuously compounded nominal and real returns

Continuously compounded nominal and real returns

Nominal return

Let Pt be the price of a security at time t, including any cash dividends or interest, and let Pt − 1 be its price at t − 1. Let RSt be the simple rate of return on the security from t − 1 to t. Then

 1 + RS_{t}=\frac{P_{t}}{P_{t-1}}.

The continuously compounded rate of return or instantaneous rate of return RCt obtained during that period is

 RC_{t}=\ln\left (\frac{P_{t}}{P_{t-1}}\right ).

If this instantaneous return is received continuously for one period, then the initial value Pt-1 will grow to P_t = P_{t-1} \cdot e^{RC_t} during that period. See also continuous compounding.

Since this analysis did not adjust for the effects of inflation on the purchasing power of Pt, RS and RC are referred to as nominal rates of return.

Real return

Let πt be the purchasing power of a dollar at time t (the number of bundles of consumption that can be purchased for $1). Then πt = 1 / (PLt), where PLt is the price level at t (the dollar price of a bundle of consumption goods). The simple inflation rate ISt from t –1 to t is \tfrac {PL_t}{PL_{t-1}} - 1. Thus, continuing the above nominal example, the final value of the investment expressed in real terms is

P_t^{real} = P_t \cdot \frac{PL_{t-1}}{PL_t}.

Then the continuously compounded real rate of return RCreal is

 RC_{t}^{real}=\ln\left (\frac{P_{t}^{real}}{P_{t-1}}\right ).

The continuously compounded real rate of return is just the continuously compounded nominal rate of return minus the continuously compounded inflation rate.

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