Why Inflation Is Not Added Separately to a Nominal Discount Rate

Summary

The document addresses whether inflation should be multiplied into a discount factor alongside the risk-free rate and a credit spread. Its explanation is that the nominal risk-free rate already reflects inflation in part: when inflation is high, the risk-free return on money would generally be expected to rise as well. Adding a separate inflation adjustment on top of a nominal rate can therefore count inflation twice.

The response also notes that the discount rate is normally quoted on an annual basis, so the discount factor must match the cash flow’s time horizon. The discussion is brief and conceptual. It does not provide a full valuation framework or distinguish nominal from real cash flows and rates in detail; consistent units and assumptions about the cash flow and discount rate remain necessary.

Key ideas

• A nominal risk-free rate incorporates an inflation component in part.
• Adding an inflation factor separately to a nominal discount rate can double-count inflation.
• Credit spreads and the risk-free rate address different components of discounting.
• The discount factor must be adjusted to match the annual rate to the cash flow horizon.

Tags

# Discounting with inflation?


# Discounting with inflation?












To discount a cash flow I am told to use interest rate plus credit risk if the cash flow has a credit risk. Why do I not include inflation in the calculation? in 2022 rates went high because the FED was hiking rates and not because the inflation was high. But the value with my 30 year cash flow gets smaller and smaller with inflation prevailing. Why is it not inflation in the discounting: $$DF=1/(1+r_{\text{free}})\times 1/(1+\text{credit spread})\times 1/(1+\text{inflation rate})$$

## Answer by Bob (score 3)

https://quant.stackexchange.com/a/75071

The reason you do not have to discount for the inflation rate, is that the risk free rate is set, in part, by the inflation rate. That is, during times of high inflation you would expect the risk free rate of money to be high.

The risk free interest rate is normally specified per year. As such, you may need to adjust your formula for DF.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.