What Is an Inflation Premium? Definition, Formula, 8 Facts

Whether you are borrowing or lending money by investing in bonds, money market funds, or other interest-bearing securities, the interest rate will reflect the current market conditions.

Numerous factors influence the fluctuation of interest rates. The inflation premium is a fundamental determinant of interest rates.

Understanding what an inflation premium is and how it influences interest rates can allow you to make wiser investing and purchasing decisions.

What Is an Inflation Premium?

A necessary return, such as the interest rate on a bank loan, bond yield, or return on equity, may be approximated by beginning with a true risk-free rate and adding premiums for each additional risk taken, such as inflation risk, default risk, etc.

What Is an Inflation Premium

Inflation premium is the extra portion of the interest rate that reflects the risk of anticipated inflation. When using the nominal risk-free rate, inflation premium must not be included.

Formula Inflation Premium

To calculate the inflation risk premium, it is necessary to compare the yields of bonds that are essentially similar, but only one of which contains inflation risk. The majority of government and business bonds are susceptible to inflation.

Nonetheless, certain government bonds are inflation-protected, meaning that their coupon payments and face value are modified depending on the change in a price index, such as the CPI. Therefore, they are not subject to inflation risk. Use the following formula to estimate the inflation premium:

Inflation Premium = YieldTB – YieldIP

Where YieldTB  is the yield on a Treasury bond and YieldIP is the yield on an inflation-protected Treasury security with the same coupon rate, maturity, etc. as YieldTB.

What Is an Inflation Premium

Using the following equation, we can get the inflation risk premium if we already have a nominal rate and a real rate.

Inflation Premium = 1 + Nominal Rate − 1
1 + Real Rate

Example Of Inflation Premium

On February 1, 2018, the US Treasury Yield Curve Rates for 5, 10, and 20-year maturities are 2.56 percent, 2.78 percent, and 2.90 percent, respectively, while the US Treasury Real Yield Curve Rates for 5, 10, and 20-year maturities are 0.63 percent, 0.67 percent, and 0.78 percent, respectively. Determine the proper inflation premium for a 10-year-term bond.

Relevant to a 10-year interest rate is the difference between nominal and real 10-year US interest rates. The estimated inflation premium is 2.11 percent (=2.78 percent minus 0.67 percent).

Function Of Inflation Premium

The major market driver that causes an inflation premium is inflation expectations. When inflation is high (as it has been to varied degrees since World War II), lenders are aware that the value of the money they will be repaid will decrease. They increase interest rates to offset the anticipated loss.

Borrowers who anticipate price increases are more likely to pay higher interest rates to acquire products and services on credit sooner rather than later, because they anticipate costs will be higher.

Components Of Inflation Premium

Interest rates consist on three factors. The first is the reward without risk. This is the interest rate charged by lenders for the use of their money when there is no danger of non-repayment.

The inflation premium is added to the risk-free rate to compensate for predicted losses caused by inflation’s erosion of the purchasing power of currency. The third factor is the price charged by lenders to mitigate credit risk.

What Is an Inflation Premium

Effects Inflation Premium

It is hard to exactly determine the inflation premium since it is dependent on future predictions. However, the inflation premium may be estimated with relative ease. This is often accomplished by beginning with the current interest rate on U.S. Treasury Inflation-Protected Securities (TIPS).

Because TIPS are practically risk-free and inflation-protected, their rate closely resembles the real-risk rate. Treasury T-Bills are equally low-risk, but they are not guaranteed against inflation.

To generate an approximation of the inflation premium, just subtract the TIIPS rate from the T-Bill rate. Utilize investments with the same maturity (10-year securities are most often used).

Significance Of Inflation Premium

Taking into account the inflation premium will provide certain benefits for an investment. Look for long-term fixed-rate securities to “lock in” high market rates when inflation is high or is predicted to drop. In contrast, if you anticipate inflation to grow, you should concentrate on variable-rate or short-term assets (if you are borrowing, the reverse is the case).

Nevertheless, inflation rate forecasting is challenging, especially for long-term investments. The majority of financial experts lay greater emphasis on the credit-risk component of interest rates.

What Is an Inflation Premium

FAQs Inflation Premium

How Do You Calculate Inflation Premium Nominal Interest And Real Interest?

Is approximated by the formula nominal interest rate = real interest rate plus inflation rate, or by assuming that actual interest rates include an inflation rate.

How Is Interest Premium Calculated?

The bond’s default risk premium must be determined by deducting all other interest rate components from its annual percentage yield (APY). Consider that the corporation in question issues bonds with a 7 percent interest rate.

What Is Inflation Premium Upsc?

In the UPSC, inflation premiums are a key subject. In other words, inflation premiums determine an investor’s return on assets or investments during periods of generally stable markets. The actual rate of interest is derived using a variable premium rate and nominal interest rates.

What Is The Inflation Premium Quizlet?

This premium, or inflation index (IP), refers to the rate of return on risk-free investments that is higher than anticipated.

What Is an Inflation Premium

How Do You Calculate Inflation Risk Premium?

When the disparity between nominal and real yields is bigger than the nominal cost of commodities, a higher projected inflation rate is calculated. Both inflation expectations and actual yields must be estimated independently.

How Do You Calculate Inflation Using Nominal And Real Rate Of Return?

The real rate of return is determined based on a one-to-one split with the inflation rate minus one, and refers to the cost of purchasing the stock after accounting for a variety of factors, including inflation. Inflation can be calculated using the consumer price index or the wholesale price index.

How Do You Calculate Interest Premium Bonds?

To determine the total interest, multiply the face value of the bond by its coupon interest rate and then by the number of years the bond will stay outstanding.

What Is Eir Method?

Using the effective interest approach, a bond or contract can be antivated or discounted. Bond discounts offered at a discount are utilized here, where they are amortized over time.

How Do You Calculate Discount And Premium?

In order to arrive at a premium/discount computation, prices and NAV are computed as a percentage of the NAV. Investors have access to an ETF share market price that is greater than the NAV by a positive number. Positive values suggest that the market for exchange-traded funds is trading below its NAV.

What Is an Inflation Premium

Conclusion

An inflation premium is the difference between the interest rate you pay for a fixed period of time versus what it would have been if the same investment had not been tied up in the same amount of time.

A rising inflation rate is often a precursor to a rising interest rate. This is because as inflation increases, people have less purchasing power. They are also less willing to borrow money at higher interest rates.

When inflation is low and interest rates are low, it’s possible to borrow money for free. In this case, the cost of borrowing money is not as relevant.

As inflation rises and interest rates increase, borrowers need to pay more in interest rates to get the same amount of money they could borrow for free.

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