What is Inflation Premium?

For investors, investing in various assets or income streams presents several risks. These risks can be specific to the asset class or the market that investors enter. Some risks may apply to all investments regardless of the type of asset or market. One of these risks includes inflationary risk associated with inflation in an economy.

What is Inflationary Risk?

Inflationary risk represents the uncertainty associated with inflation affecting the future value of an investment or asset. Inflationary risk comes with inflation, which is the rise in prices in an economy. It also causes the loss of purchasing power. Therefore, the inflationary risk is the risk that an increase in prices or reduction in purchasing power impacts asset or investment value.

For investors, it is crucial to ensure that the returns from any investment at least exceed the inflation rate. If it doesn’t, then the investment is loss-making. Similarly, it results in a reduction in the value of the investment. Therefore, inflationary risk can cause investors to lose money on their investments. This risk depends on how inflation fluctuates in an economy. Investors will also require an inflation premium for the inflation risk they take.

What is Inflation Premium?

Inflation premium represents the compensation that investors require to make on investments impacted by inflation risk. Inflation premium is a component of the required return. With an inflation premium, investors can earn from these risks of loss of purchasing power or increasing prices. It arises from investors holding nominal assets that suffer due to unanticipated changes in inflation.

Investors require an inflation premium to compensate them for the risk they take associated with inflation fluctuations. Since these risks are unpredictable, investors use the inflation premium to account for such uncertainty. Inflation premium represents an interest rate that investors can add to the real risk-free rate to compensate for fluctuations in inflation.

How to calculate the Inflation Premium?

Investors can calculate the inflation premium by taking the ratio of two identical bonds. One of these bonds must carry inflation risk while the other doesn’t. In most cases, investors can use government bonds to calculate the inflation premium. Some treasury bonds come as inflation-protected. Therefore, these bonds account for inflation in both the face value and coupon payments.

Investors can use these inflation-protected treasury bonds and compare their yield to the yield from nominal treasury bonds. This way, they can calculate the inflation premium. In this case, the inflation premium formula will be as follows.

Inflation Premium = Yield on treasury bonds – Yield on inflation-protected treasury bonds

Investors can also calculate the inflation premium through nominal and real rates. The formula for inflation premium using these rates is as follows.

Inflation Premium = (1 + Nominal Rate / 1 + Real Rate) – 1

Example

The treasury yield curve for 10-year bonds on 03 May 2021 was 1.63%. The real treasury yield curve for 10-year bonds on the same date was -0.79%. Therefore, the inflation premium at the time will be as follows.

Inflation Premium = Yield on treasury bonds – Yield on inflation-protected treasury bonds

Inflation Premium = 1.63% – (-0.79%)

Inflation Premium = 2.42%

Conclusion

Inflationary risk represents the risk that investment values will fluctuate due to fluctuations in the inflation rate. Inflation premium is the compensation that investors can expect for these fluctuations. It arises from the fact that investors hold nominal assets which are subject to inflation. Investors can calculate the inflation premium using one of the two ways discussed above.

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