Quantitative Methods for Finance - Essay Example

So, when we express financial data as real or as current price variables, it is essentially a distinction between whether we are providing the ‘real’ or the ‘nominal’ value of the variable. The fundamental difference is that while ‘nominal’ values are not adjusted for inflation and therefore may reflect changes in values just because of fluctuations in the price level, the ‘real’ values will only change if there are changes that cause the underlying variable to change. Price level changes do not affect ‘real’ financial data. (b) The CPI Vs the RPI in the UK as alternative measures of inflation The Consumer Price Index (CPI) or Harmonised Indices of Consumer prices (HICP) as they were previously known until 2003 in the UK are computed for EU member state to facilitate international comparability of inflation.

The statistical wing of the European Commission known as Eurostat has been publishing monthly HICP values for all member states since the 1st quarter of 1997. Inter-economy inflation comparisons are provided in these reports. Prior to the development of the HICP comparing rates of inflation across members of the European Union was not feasible due to differences in the mechanisms of each members in their computations of CPIs. Apart from differences in methodology, the included basket of goods was also disparate across the countries.

So, for the UK, the CPI measures changes in the general price level reflected in the changing costs to purchase the same basket of goods and services typically consumed by UK households. In the UK, the RPI (retail price index) is also computed and it is also a measure of changes in the price level. The CPI and the RPI cover a similar basket of goods although there are important differences. A number of commodities included in the RPI goods are excluded from the CPI. For instance the CPI does not include council tax, fees of estate agents, repayments on mortgages, education and healthcare related expenses and building insurance.

Certain other aspects which are rather technically difficult to integrate into an international index due to international differences are also excluded from the CPI but included in the RPI. For instance, in aspects of the economy such as education and health, a number of commodities are substantially subsidised and the extent of subsidization is different considerably for the different members of the EU. Consequentially, including these in an internationally comparable CPI is not possible. The RPI however includes these under its wing.

There are certain expenditures on the other hand that are included in the CPI but not accounted for in the RPI. For instance, air fares or personal computer expenses are accounted for in the CPI but not in the RPI. Specifically, the eurostat sets one part of the total expenses of thousand consumers as the threshold for inclusion in the CPI. Any commodity that accounts for higher expenses compared to the threshold is included in the CPI. All private households are included in the CPI but the RPI excludes the top 4 percent of the income distribution.

Additionally, households that derive equal to or more than 75 percent from state benefits are also excluded from the RPI. Typically, since the CPI does not include majority of the housing related expenses included in the RPI, the RPI tends to typically have a higher value than the CPI. However, both measures