The inflation premium is a method used to calculate the normal rate of return on an asset or investment when the total cost of goods and services increases over time.
The inflation premium is a method used in investing and banking to calculate the normal rate of return on an asset or investment when the total cost of goods and services increases over time, known as inflation. The real return, therefore, or the real rate of return on an investment, is reduced by the inflation premium, and this reduction tends to be greater the later the investment matures. An example of this would be a government bond that produces a 5% return on investment in one year, but with an inflation premium of 1% during the same year for price increases. This reduces the real yield on the bond to 4% at the end of the year.
Inflation risk has a significant impact on the value of investments over time, especially if they are investments with a very long horizon before maturity. Government bonds that take 25 to 30 years to mature can actually result in less value than the initial investment due to an inflation premium over that period that cancels out the small percentage yield on the bond’s earnings. Due to the effect of inflation on the nominal return of any investment, predicting the rate of inflation over time is an important component of any financial investment.
Because the risk of inflation can lead to a negative return or loss of value for an investment, it is important that a long-term security, such as a bond, calculate inflation by linking it to the coupon rate. The coupon rate is the percentage yield on the bond based on current interest rates. Inflation raises interest rates in the economy as a whole, and if investment returns are not adjusted to compensate for this over time, they will lose value.
The yield curve of an investment does not only take into account the inflation premium and interest rates. Of equal importance is what is known as the risk premium. A risk premium is an estimate of the probability that the business invested in fails while the investment is maturing, where the full value of the security could be lost.
When investments have returns linked to rising interest rates, such as bonds, those returns are based on what is called the nominal interest rate. The nominal interest rate is a value obtained without taking into account inflation. To get this nominal rate of return on an investment, three other demeaning factors are added to and subtracted from the investment’s stated return. The nominal interest rate, therefore, equals the real return on the investment when it is withdrawn.
An example of how this is calculated can be illustrated with a bond that has a stated yield of 8% and matures in one year. If the real interest rate for the year is 1%, the inflation premium is 2%, and the risk premium is 3%, then the real yield on the bond or the nominal interest rate will be only 2%, since all these other factors are costs that degrade the value of the bond. In practice, however, it is common for the risk premium to be removed from these calculations if a company is considered to be very stable and likely to fail in the short or long term. Because risk premiums are more theoretical than actual costs, such as the inflation premium or real interest, if posted to net income, they often end up making the return on the investment appear less than it actually is when it is charged.