What is the formula for calculating the real risk-free rate?

The formula for calculating the real risk-free rate involves adjusting the nominal risk-free rate to account for the effects of inflation. This adjustment is necessary because the nominal rate does not reflect the true purchasing power of money over time.

The correct approach is to use the formula:

Real Risk-Free Rate = (1 + Nominal Risk-Free Rate) / (1 + Inflation Rate) - 1.

This formula recognizes that the effects of compounding need to be taken into account when adjusting for inflation. It divides the nominal rate by the inflated equivalent, ensuring that the result gives a clearer picture of the actual rate of return after removing the influence of inflation.

Thus, option B correctly encapsulates this reasoning by applying the formula in another form. This calculation allows investors and analysts to understand the true yield from investments when inflation is factored in, helping them to make more informed decisions regarding asset allocations and investment strategies.