1 Chapter 4

2 Real and Money Interest Rates

2.1 Real rates of interest
An investor’s basic objective is to maximise the interest rate of return. So, if an investor has to
choose between a number of possible investment opportunities then, other things being equal,
the higher the interest rate the better.
However, price inflation is often present, i.e. there is a tendency for the prices of goods
to increase gradually (or rapidly) over time. This means that the "purchasing power" of a
specified sum of money tends to be eroded as time passes.

Example 4.1.1
A pensioner has just invested $3 000 in a government savings account that guarantees to provide
a rate of return of 7 41 % per annum over the next 5 years.
(a) How much will the pensioner have at the end of the 5 years?
(b) If toasters currently cost $30 each and are expected to increase in price by 2 12 % per annum
over the next 5 years, how many toasters could be bought now with the initial investment and
with the proceeds at the end of the 5 years?
(c) Comment on your answers to (a) and (b).

Solution (a) By the end of the 5 years the account will have accumulated to:

3, 000 × (1 + i)5 = 3000 × 1.07255 = 3000 × 1.4190 = $4, 257

(b) The $3, 000 invested could buy 3, 000/30 = 100 toasters. At the end of the 5 years toasters
will cost $30 ×1.0255 = $ 33.94 each.
So the proceeds will be able to buy 4, 257/33.94 = 125 toasters.
(c) In money terms, the fund has grown by 41.9%, but in terms of the number of toasters it
will buy, it has only grown by 25%, i.e. there has been an erosion in purchasing power caused
by price inflation.
When you are considering investments, it is often more useful to look at the rate of return
earned on an investment after taking into account the erosion caused by inflation. This is done
by looking at the real rate of interest (or real rate of return).
The real rate of interest of a transaction is the rate of interest after allowing for the effect
of inflation on a payment series.

2.2 Inflation adjusted cashflows

The effect of inflation means that a unit of money at, say, time 0 has a different purchasing
power than a unit of money at any other time. We find the real rate of interest by first adjusting
all payment amounts for inflation, so that they are all expressed in units of purchasing power
at the same date.
As a simple example, consider a transaction represented by the following payment line:

1
 That is, for an investment of 100 at time 0 an investor receives 120 at time 1 .
The effective rate of interest on this transaction is clearly 20% per annum. The real rate
of return is found by first expressing both payments in units of the same purchasing power.
Suppose that inflation over this one year period is 5% per annum. This means that 120 at time
1 has a value of 120/1.05 = 114.286 in terms of time 0 money units. So, in "real" terms, that
is, after adjusting for the rate of inflation, the transaction is represented as:

Hence, the real rate of interest is 14.286%.

2.2.1 Calculating real yields using an inflation index

The symbol Q refers to a well-defined "basket" of commodities/services available in the econ-
omy. Define Q(t), t ∈ [0, T ] to be the value of this basket at time t.
This basket represents the inflation index which is used to calculate the increase in prices
of goods/services in the economy (inflation).Note that if the inflation rate is negative then we
call it deflation.
Thus if the index stands at 100 at time 0 , i.e. Q(0) = 100 and at time 1, Q(1) = 105; then
inflation was 5% over the time period 0 to 1 .
Where the rates of inflation are known (that is, we are looking back in time at a transaction
that is complete) we may adjust payments for the rate of inflation by reference to a relevant
inflation index.
For example, assume we have an inflation index, Q (tk ) at time tk , and a payment series as
follows:

Clearly the rate of interest on this transaction is 8%.

This is because for an initial investment of 100 , we receive interest payments of 8 at the
end of each year plus a return of capital at the end of three years. If you are still not sure then
check that 8% solves the equation of value:
100 = 8a 3 + 100v 3

2
Now we can change all these amounts into time 0 money values by dividing the payment at time t
by the proportional increase in the inflation index from 0 to t. For example, the inflationadjusted
value of the payment of 8 at time 1 is 8 ÷ (Q(1)/Q(0)). The series of payments in time 0 money
is then as follows:
Time t : 0 1 2 3
| | |
Payment: −100 7.6923 7.2289 92.5714
Note that the real value (inflation-adjusted values) are smaller than the actual cash amounts.
Also note that these real values depend on the chosen inflation index. Different indices
result in different real values.
This gives a yield equation for the real yield:
−100 + 7.6923vi′ + 7.2289vi2′ + 92.5714vi3′ = 0
where i′ is the real rate of interest which can be solved using numerical methods (use your
financial calculator ) to give i′ = 2.63%. Therefore assuming a constant annual rate of inflation
j over the 3 year period, we have j = 0.0523239 = 5.23%
In general, the real yield equation for a series of cashflows {Ct0 , Ct1 , . . . , Ctn }, given associ-
ated inflation index values {Q(0), Q (t1 ) , Q (t2 ) , . . . , Q (tn )}, is, using time 0 money units:
n
X Q(0) tk
Ctk v′ =0
k=0
Q (tk ) i
n
X Ctk tk
⇒ vi′ = 0
k=0
Q (tk)

Until now we have been expressing all payments in terms of time 0 money units. However, this
choice was arbitrary, as we could have chosen any date on which to value all the payments.

2.2.2 Calculating real yields given constant inflation assumptions

If we are considering future cashflows, the actual inflation experience will not be known and
some assumption about future inflation will be required. For example, if it is assumed that a
constant rate of inflation of j per annum will be experienced, then a cashflow of, say, 100 due
at t has value 100(1 + j)−t in time 0 money values.
So, for a fixed net cashflow series {Ctk } , k = 0, 1, 2, . . . , n, assuming a rate of inflation of j
per annum, the real, effective rate of interest, i′ , is the solution of the real yield equation:
n
X
Ctk vjtk vit′k = 0
k=0

We also know that the effective rate of interest with no inflation adjustment which may be
called the "money yield" to distinguish from the real yield, is i where
n
X
Ctk vitk = 0
k=1

So the relationship between the real yield ir , the rate of inflation j and the money yield i is
vi = vj vi′ .

3
 1+i i−j
Therefore 1 + ir = 1+j ⇒ ir = 1+j .
This is sometimes approximated to ir = i − j if only estimates are required. However
you should only use this approximation if the question specifically asks for an estimate or an
approximation since the "exact" method isn’t much more difficult.

Example 4.2.1
Ten years ago, a saver invested $5,000 in an investment fund operated by an insurance company.
Over this period the rate of return earned by the fund has averaged 12% per annum. If prices
have increased by 80% over this period, calculate the average annual real rate of interest earned
by the fund over this period.
Solution
The average annual rate of inflation j over the 10 year period can be found from:

(1 + j)10 = 1.8 ⇒ j = 1.81/10 − 1 = 0.0605 i.e. 6.05%

The average annual rate of interest is i = 0.12. So the average annual real rate is:
0.12 − 0.0605
ir = = 0.0561 i.e. 5.61%
1.0605
The graph below shows the real growth over time of a single investment when the rate of
inflation is (a) higher than, (b) equal to, and (c) less than the rate of interest (taken to be 8%
per annum).

4
 If an investment is achieving a positive real rate of return (i > j), then it is outstripping
inflation. If it is achieving a negative real rate of return (i < j), then it is falling behind inflation
(which means that you would be better spending the money now, rather than "investing" it).

Example 4.2.2
You are the investment manager for a pension scheme. The trustees have paid over a sum of
$250, 000 instructing you to invest it so as to obtain the highest real rate of return over the
next 5 years. Your researchers have advised you that suitable investments are available in the
following countries:

Expected rate of return Expected inflation rate

Japan: 3%pa 1%pa

United Kingdom: 7%pa 3%pa
Malaysia: 15%pa 10%pa
Mexico: 25%pa 40%pa

5
 Which country would you select? (Assume that the investment opportunities in each country
are otherwise identical and ignore currency risks and all other factors that might influence your
decision.)
Expected rate of return Expected inflation rate Real rate of return
3%pa 1%pa 2%pa
Solution 7%pa 3%pa 4%pa
15%pa 10%pa 5%pa
25%pa 40%pa −15%pa∗∗
∗∗ i−j
This has been calculated using the approximate relationship. If you use 1+j you will
obtain a real rate of return of −10.7%. This example shows how the approximation does not
work so well at higher rates of interest.
So Malaysia is expected to provide the highest real rate of return (5% per annum approxi-
mately).
In some cases a combination of known inflation index values and an assumed future inflation
rate may be used to find the real rate of interest.
Note that the calculations for real rates of interest are very similar to the calculations used
for valuing compound increasing annuities (and, in fact, the formulae are identical). Formulae
of this type, which involve applying an adjustment to the interest rate used in calculations, arise
frequently in actuarial work in situations where there is a second factor, apart from interest,
influencing the growth of a fund.

2.3 Indexation of cashflows

Some contracts specify that the cashflows will be adjusted to allow for future inflation, usually
in terms of a given inflation index. The index-linked government security is an example. The
actual (monetary) cashflows will be unknown until the inflation index at the relevant dates are
known. The contract cashflows will be specified in terms of some nominal amount to be paid
at time t, say ct . If the inflation index at the base date is Q(0) and the relevant value for the
time t payment is Q(t) then the actual (monetary) cashflow is

Q(t)
C t = ct
Q(0)
There are two yields which may interest Pn us here,tk thePnormal yield i, unadjusted for inflation,
which we get from the yield equation k=0 Ctk vi = nk=0 ctk Q(t k)
Q(0)
= 0 and the real yield ir .
It is easy to show that if the real yield ir is calculated by reference to the same inflation
index as is used to inflate the cashflows, then ir is the solution of the real yield equation:
n
X Q(0) tk
Ctk v =0
k=0
Q (tk ) ir
n
X
⇒ ctk vitk = 0
k=0

In other words we can solve the yield equation using the nominal amounts.
However, it is not always the case that the index used to inflate the cashflows is the same
as that used to calculate the real yield. For example, the index linked UK government security

6
has coupons inflated by reference to the inflation index value 8 months before the payment is
made. The real yield, however, is calculated using the inflation index at the actual payment
dates.
If the inflation index at the base date is Q(0) and the relevant value for the time t payment
is Q(t) and cashflows are indexed with respect to the inflation index value with a time lag LAG
then the actual (monetary) cashflow is

Q(t − LAG)
C t = ct .
Q(0 − LAG)

However the real values with respect to the date of purchase will be Ct Q(0)
Q(t)
This makes things a little more complicated and is illustrated in the example below.
Example 4.3.1 A three-year index-linked security is issued at time 0. The security pays
nominal coupons of 4% annually in arrear and is redeemed at par. The coupons and capital
payment are inflated by reference to the inflation index value 8 months before the payment is
made. The inflation index value 8 months before issue was 110 . The table below shows the
index values at other times.
4 4 4
Time 0 12
1 1 12 2 2 12 3
Index 112 115 116 118 119 122 125
Calculate the real yield if the price of the stock is 100.
Solution First we must calculate the monetary amount of each payment using the inflation
index values 8 months before the payment date. We will then express these amounts in terms
of time 0 money units. The results are shown in the following table.
Time(In Years) 1 2 3
Nominal ct 4 4 104
Q(t−LAG) 115 118 122
Monetary payment Ct = ct Q(0,LAG) 4 × 110 = 4.18 4 × 110 = 4.20 104 × 110 = 115.35
Payment in time 0 units Ct · Q(0)
Q(t)
112
4.18 × 116 112
= 4.04 4.29 × 119 = 4.04 115.35 × 112
125
= 103.35
The real yield is then found by solving for i the equation of value:

100 = 4.04v + 4.04v 2 + 103.35v 3

which gives, by trial and error or other method, a real yield of 3.82%.
Note that, we could also have calculated the normal yield i as :

100 = 4.18v + 4.20v 2 + 115.35v 3

which gives i = 7.63949%. We could still have got a good estimate of this value by considering
that the average inflation growth rate for the 3 years is j = 3.733% and if ir = 3.82%, then
from
i−j
ir = 1+j , we get i = 7.69561%, not exactly the same as the above but a good estimate.

Example 4.3.2
The values of the Retail Price Index are given in the following table:

7
 Date RP I
Dec 1991 100
June 1992 105
Dec 1992 107
June 1993 110
Dec 1993 112
June 1994 116
Dec 1994 119
June 1995 120
Given a level annuity that pays $100 every six months starting on 1 December 1991 and
ending with a final payment on 1 June 1995, compute an inflation-adjusted present value for
this contract using an effective rate of interest of 10% per annum.
Solution: At focal date 1 Dec 1991, the known future cash flows of amount Cke = 100 at times
k = 0, 1, . . . , 7 have a lower purchasing power than 100 at the focal date. The inflation-adjusted
or real (t = 0) values of the repayments are given in the table:
k 21 years ) 0 1 2 3 4 5 6 7
e
Ck 100 100 100 100 100 100 100 100
0 e Q(0)
Ck = Ck Q(k) 100 95.24 93.46 90.91 89.29 86.21 84.03 83.33
The inflation-adjusted or real NPV is

NPVR (i = 10% p.a. ) =100 + 95.24v 1/2 + 93.46v + 90.91v 3/2 + 89.29v 2
+ 86.21v 5/2 + 84.03v 3 + 83.33v 7/2
=619.21

Example 4.3.3
A loan of $25 000 was issued and repaid at par after 3 years. Interest was paid on the loan at a
rate of 8% per annum payable annually in arrears. Calculate the real rate of return if the value
of the RPI is expected to increase by 5% per annum.

−25000

8
 −25000
Here Q(t) = Q(0)(1.05)t ∴ Q(0)
Q(t)
= (1.05)−t
e −α
Real rate of return = iQ = i1+α where α = 5%

8% − 5%
= = 2.8671% p.a.
1.05

2.4 Example 4.3.4

A sheep farmer is considering increasing the size of his flock from 3000 to 4500 heads on his
400 acre farm. According to his calculations (which are all based on 1985 prices) this would
give an additional annual profit, after allowing for replacement of sheep but not for financing
costs, of $1.91 per extra sheep. The initial costs associated with increase of size of the flock are
as follows:
Purchase price of 1500 sheep 4292
Fencing 1850
Reseeding 400 acres 8000
Total $14142
In addition there is an annual cost of $3.27 per reseeded acre for fertilizer. The fencing may
be assumed to last for 20 years and the resale value (after 20 years) of the extra sheep is taken
as zero.
(a) Assuming that there will be no inflation and that the net profit each year will be received
at the end of the year, find the internal rate of return for the project.
(b) What uniform annual rate of inflation will make the project viable, if the farmer may
borrow and invest money at 10% per annum interest?
Solution: (a) To find IRR solve for i :

14142 = 1557a 20| ⇒ i = 9.0705%

i

Note that as the above stream is based on t = 0 values, we have iQ = 9.0705%.

b) Let α = annual inflation and suppose Q(t) = Q(0)(1 + α)t .

9
 Then payment stream e has yield
ie = iQ (1 + α) + α = (9.0705%)(1 + α) + α
The project will be viable as long as
ie > 10% per annum
⇒(9.0705%)(1 + α) + α > 10%
⇒α(1.090705) > (10 − 9.0705)%
⇒α > 0.85% p.a.

Example 4.3.5
An annuity certain pays $2500 annually in arrears for a term of 5 years. An investor offers to
purchase the annuity based on achieving a real yield of 5% per annum assuming an escalation
in the RPI of 6% per annum.
(a) What price does the investor offer? (b) Assume the offer is accepted. The relevant RPI
values turn out to be:
Time k 0 1 2 3 4 5
RPI 721 761 811 868 928 987
where k is measured from the purchase date. Calculate the investors real yield based on these
RPI figures, assuming the investor holds the annuity for the full term.
(c) Finally, suppose now that instead of holding the annuity for the full term, the investor
sells the annuity exactly 2 years after the purchase date to a second investor who offers a price
based on an effective 10% per annum unadjusted for inflation. What is the real yield on the
first investors 2 year investment?

(a)
P = NPVR (5%) where Q(t) = Q(0)(1.06)t
= NPVe (ie ) where ie = iQ (1.06) + 6% = 11.3%
= 2500a 5 11.3%
= 9170.44
(b) To find realised real rate of return, solve for i :
 
721 721 2 721 3 721 4 721 5
9170.44 = 2500 v+ v + v + v + v
761 811 868 928 987
⇒ i = 4.6858% p.a.

10
(c) Finally, suppose original investor sells after 2 years:

Price = 2500a 3 10 % = 6217.13

Real yield is now found by solving for i :

721 721 2
9170.44 = 2500 v + (2500 + 6217.13) v
761 811
⇒ i = 5.7452% p.a.

Example 4.3.6
A company director is contracted for 2 years and paid a net salary of $4 000 per month inflation
linked to the Motor Industries Index (MII) with a time lag of 4 months. The director offers
an investor 10% of his monthly salary payments over the two year period in return for a loan
immediately. The investor assumes the MII will escalate at approximately 5% per annum and
values the payments at 7% per annum effective, the rate at which he may borrow money. What
amount is loaned? Assume the investor is correct about the MII. What is the investors real
rate of return as measured against the CP I which escalates at approximately 4% per annum
over the same period?
Solution:
Investor receives (hopefully)

Convert to monthly rates:

(1.05)1/12 = 1.004074124 and E.R. = 0.565414537% p.m.

0.5654% − 0.4074%
∴ P V = 4000a 24 j where j = = 0.157%
1.004074
= 94137.15


Real rate p.m. (with respect to CPI) = iQ solving NPVR iQ = 0 for Q(t) = (1.04)t/12 =
(1.00327374)t . As NPVe (0.5654%) = 0
0.5654% − 0.32737%
⇒ iQ = = 0.23726% p.m.
1.00327374
Convert to annual rate: Real rate p.a. = 2.8846% p.a.

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2.5 Index-Linked Bonds
These contracts form a variation on the standard contract. The contract specifies:

D ··· nominal coupon rate per annum

R ··· nominal redemption rate
Q ··· inflation index (RPI/CPIX etc.)
LAG ··· time lag for use with Q.

In addition, the contract specifies the redemption date and the coupon payment dates as usual.
Index-related securities aim to provide a positive real rate of return to the investor by linking
the monetary amount of each payment to the nominal amount through the use of index Q :

The monetary amount of each coupon and the final redemption payment is increased in the
same proportion as the proportional increase of the lagged index from the issue date to the
cash flow date.
Consider now an investor who purchases this security at date t0 > 0. The investor aims to
secure a positive real rate of return measured relative to the purchase date t0 :

12
3 Observations:
1. The goal is to be able to calculate the purchase price given iR (or vice versa) on the
purchase date.

2. The values Q (t0 ) and Q(t) in the above diagram are not known at the purchase date and
so must be inferred from historical data and future outlook.

4 The important dates for price/yield evaluation

Assumption: Suppose initially that

t − LAG > tL

13
for each cash flow date t > purchase date t0 .
This assumption implies that all nominal cash flows occurring after the purchase date have
unknown monetary amount at that date.
The case where this assumption does not hold is easily dealt with subsequently.
Common practice: As noted in observation (2) of the previous page, the cash flows of
payment stream Real require values of Q(t) where t > tL .
A common estimation is:

Q(t) = Q (tL ) (1 + α)t−tL , t > tL

Generally the investor uses a range of values for α (based on historical data and future outlook)
and finds the relationship between the purchase price and the real yield in each case.
The Real Equation of Value
X Q(t − LAG) Q (t0 ) t−t0
P VR (iR ) = Xt v
Q(0 − LAG) Q(t) @iR
Cash flow
dates t > t0
Q (t0 ) X Q (tL ) (1 + α)t−LAG−tL
t−t0
= Xt v@i
Q(0 − LAG) t Q (tL ) (1 + α)t−tL R

Q (t0 ) X
t−t0
= Xt v@i
Q(0 − LAG)(1 + α)LAG t R

Hence:
Q(tL )(1+α)t0 −tL
PVR (iR ) = Q(0−LAG)(1+α)LAG
P VN (iR )
PVR (iR )Q(0−LAG)(1+α)LAG
OR: Q(tL )(1+α)t0 −tL
= P VN (iR )

5 Reality Check
A common time lag is LAG = 8 months. The first coupon paid after the purchase date is then
often of known monetary amount at the purchase date equal to
Q (t1 − LAG)
X , where X = 1 st nominal coupon amount at time t1
Q(0 − LAG)
In the previous analysis the first coupon had monetary amount

Q (tL ) (1 + α)(t1 −LAG)−tL

X
Q(0 − LAG)
The difference in monetary values is
X
Q (tL ) (1 + α)(t−LAG)−tL − Q (t1 − LAG)
 
Q(0 − LAG)
As long as
Q (tL )
≈ (1 + α)tL− (t1 −LAG)
Q (t1 − LAG)

14
the above difference is a very small fraction of the 1st coupon. In the real equation of value this
difference is reduced to get a real amount and then discounted. Generally this contribution is
so small as to hardly make it worth the effort to work with the true equation of value in this
case. Even in this case we resort to the real equation of value on the previous page.
Example 4.4.1 On 21 December 1983 an investor, who is not liable to taxation, purchased
a quantity of 2% Index-Linked Treasury Stock 1996 at a price of $106.375 percent nominal. At
the time of purchase, using the latest available RPI value, he estimated his real yield on the
transaction on the assumption that he would hold the stock until redemption and that the RPI
would grow continuously at a constant rate of (a) 5% per annum and (b) 7% per annum.
Given the information below, find the estimates made by the investor of his real yield under
each assumption.
On 21 December 1983 the latest known value of the RPI was 341.9 for November 1983.
(This value was published on 16 December 1983 and related to 15 November 1983.) Issued:
16/3/1981; redeemed at par: 16/9/1996; index linked coupons at 2% p.a. paid on 16/3 and 16/9
annually. The values of the RPI for July 1980 and July 1983 are 267.9 and 336.5 respectively.
Solution:
LAG = 8 months t0 t
tL 21/12/83 16/3/84
16/9/96
Latest RPI
known at
Issue First coupon
16/3/81 15/11/83 date
Date after t0
purchase
date
Redemption
date
Q(t − LAG) = 336.5
Q(0 − LAG ) Q (tL ) = 341.9
(known coupon at t0 )
We will solve this exercise from two perspectives. The first is to acknowledge, as discussed
before, that the value of Q (t1 − LAG) = 336.5 (which corresponds to the the first coupon paid
on 16/3/84) is known, so we cannot estimate this value based on the last known value Q (tL ).
We then establish our equation of value as follows
Q (t1 − LAG) Q (t0 ) t1 −t0 X Q(t − LAG) Q (t0 ) t−t0
P VR (iR ) = Xt1 · v + Xt v
Q(0 − LAG) Q (t1 ) @iR Cash fow
Q(0 − LAG) Q(t) @iR
dates t>t1

Substituting, we get
36
336.5(1 + α) 365 86 341.9(1 + α)36/365 h 86/365  (2) 12.5
i
106.375 = 36 86 v 665 + v 2a 12.5
+ 100v
267.9(1 + α) 365 + 365 267.9(1 + α)8/12

Case 1: α = 5% per annum

The equation of value simplifies to:
86
 
(2)
106.375 = 1.24171v 86/365 + 1.2413v 365 2a 12.5 + 100v 12.5

15
Use interpolation to find v = 0.966384 ⇒ annual effective real yield = 3.47849% p.a.
Case 2: α = 7%
The equation of value is now approximately:
86
 
(2)
106.375 = 1.2362v 86/365 + 1.2413v 135 2a 12.5 + 100v 12.5

∴ v = 0.966389 ⇒ annual effective real yield = 3.47801% p.a.

But, lets assume that we can just approximate all the values of Q(t) for t > tL , so that the
formula derived above applies.
Then using an annual rate of escalation α in the index from time tL , the approximate real
equation of value is:

341.9(1 + α)36/365 h 86/365  (2) 12.5

i
106.375 = v 2ä 13
+ 100v
267.9(1 + α)8/12

Case 1: α = 5% per annum

The equation of value simplifies to:
 
86/365 (2) 12.5
85.6938 = v 2ä 13 + 100v

Use interpolation to find v = 0.966382 ⇒ annual effective real yield = 3.47874% p.a. or the
nominal real yield convertible twice = 3.44878% p.a.
Case 2: α = 7%
The equation of value is now approximately:
 
(2)
86.6172 = v 86/365 2ä 13 + 100v 12.5

∴ v = 0.967316 ⇒ annual effective real yield = 3.37878% p.a. or nominal real yield convertible
twice = 3.35072% p.a.
We can see that the yield is approximately the same especially for α = 5%. This is because
Q(tL )
Q(t1 −LAG)
= 341.9
336.5
= 1.01605 and
36 1 8
(1 + α)tL −(t1 −LAG) = (1 + α) (tL −t1 )+LAG) = (1 + α) 365 + 2 + 12 = 1.06368 if α = 5% and equals
1.08939 if α = 7%. Of these two, the first one i.e 1.06368 is closer to 1.01605 thus confirming
(4.4.1). Therefore if (4.4.1) is satisfied, the approximate value is closer to the real value.
But the correct way is to use the first method which admittedly takes more calculations
than the approximate value. Unless otherwise stated, you should always inflate the first coupon
1 −LAG)
with Q(t
Q(0−LAG)
and the rest of the coupons received after time t1 would be each inflated by
Q(tL )(1+α)t−tL −LAG
Q(0−LAG)
,t > t1 .

16