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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 general cost of goods and services rises over time, known as inflation. The real return, therefore, or real rate of return, on an investment is reduced by the inflation premium, and this reduction tends to be greater the longer that the investment takes to mature. An example of this would be a government bond that yields a 5% return on the investment in one year, but with an inflation premium over the course of the same year of 1% for the increase in prices. This reduces the real return of the bond to 4% by the end of the year.
Inflation risk has a significant impact on the value of investments over time, particularly 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 being worth less than the initial investment due to an inflation premium over such a period that negates the small percentage yield of profit on the bond. Due to the effect of inflation on nominal return for any investment, predicting the inflation rate over time is an important component of all financial investing.
Since inflation risk can result in a negative yield or loss in value for an investment, it is important for a long-term security like a bond to factor in inflation by tying it to the coupon rate. The coupon rate is the percentage yield of the bond based on current interest rates. Inflation increases interest rates in the economy overall, and, if the yield on investments is not adjusted to compensate for this over time, they will lose value.
The yield curve for an investment does not merely take into account the inflation premium and interest rates, however. Of equal importance is what is known as the risk premium. A risk premium is a calculation of how likely the business that has been invested in will go bankrupt while the investment is maturing, where the entire value of the security could be lost.
When investments that have yields tied to rising interest rates like bonds, these yields are said to be based on what is called the nominal interest rate. The nominal interest rate is a value arrived at without factoring in inflation. To get this nominal rate yield for an investment, three other degrading factors are added together and subtracted from the stated yield for the investment. The nominal interest rate, therefore, is the same as the real return on the investment when it is cashed out.
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 actual return for the bond or nominal interest rate will only be 2%, as all of these other factors are costs that degrade the value of the bond. In practice, however, it is often the case that the risk premium is dropped from these calculations if a company is considered to be very stable and unlikely to go out of business in the short or long term. Since risk premiums are more theoretical than actual costs like the inflation premium or real interest, if they are factored into a net yield, they often end up making the profit on the investment look like less than it actually turns out to be when cashed out.
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