Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 6.00% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i. e., if averaging is required, use the arithmetic average.

Real rate of return = 0.94%

Explanation:

The relationship between the nominal rates of return, real rate of return and inflation is:

(1 + nominal rate) = (1 + real rate) * (1 + inflation)

or, (1.07) = (1 + real rate) * (1.06)

Hence, the real rate of return is = (1.07) / (1.06) = (1 + real rate of return)

1.0094 = 1 + real rate of return

Real rate of return = 0.94%