### CFA Practice Question

The reason lenders don't like inflations is:
I. Lenders normally is not compensated for higher than expectation inflation levels.
II. If inflation is lower than expectations, lenders actually make some extra "profits" from the inflation expectations. However, lenders are generally not compensated for the uncertainty here.
III. Inflation causes nominal interest rates to be higher than real interest rates.
A. I and II.
B. I, II and III.
C. I and III.
Explanation: Inflation expectation is normally integrated into loan interest rate. If actual inflation is higher than this over the loan period, then lenders will lose some of the purchasing power of the loaned principal.

User Comment
danlan I think III is right also.
mtcfa I guess III may be false if there is deflation. But I thought it was correct as well.
eddeb (1+NRFR)=(1+real)*(1+Inlf)

III should be right... Don't understand
nike III is a correct statement but not the reason why lenders don't like inflations. The reason has to do with expectations and the lender know already that inflations make nominal r > real r.
mark98007 II is wrong; they price according to expectations; sometimes they gain, sometimes they lose... the times they gain ARE a form of compensation;
jjohnson II is correct. Lenders are risk-averse like normal people. Although the expected value of inflationary payoffs is certain, they don't like the variation of such payoffs. The variation, or the risk, is what is not compensated.

Think about this: you are given two choices. One is to receive \$10,000 but the chance is 10%. Another is to receive \$1,000. The expected value of the two choices is the same but the first choice is risky. Normal people would ask for a compensation in order to take choice 1.
Dinosaur III is a correct statement but it is not the reason why lenders don't like inflation.
akjohn1 I agree that III is a correct statement. I also think this is one of the reasons lenders don't like inflation. My example will be hyperbolic, but will illustrate the point nonetheless.

Consider a lender who lends at 10% and expects inflation to be nonexistant. The real interest rate he captures if this comes to fruition is 10%. If the lender's expectations are incorrect and inflation is actually 10%, then his nominal interest rate is 10%, but his real interest rate is 0%, and he does not capture any real benefit by lending. This is one of the reasons lenders don't like inflation. It's because nominal IR being above real IR eats into their economic profits of lending.
aragarwal as per the definition of the nominal interest rate from wikipedia.( Nominal interest rate doesnt take inflation into account compared to real interest rate)....so iii is wrong.
moneyguy well if wikipedia says so, it must be so...
Come on, aragarwal!