The inflation premium is a method used to calculate the normal rate of return on an asset or investment when the overall 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 overall cost of goods and services increases 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 the investment takes to mature. An example of this would be a government bond that yields a 5% return on investment in one year, but with a 1% inflation premium over the same year for rising prices. This reduces the bond’s actual return 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 may actually result in being worth less than the initial investment due to an inflation premium during that period that cancels out the small percentage yield of 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 inflation risk can result in negative yield or loss of value for an investment, it is important that a long-term security such as a bond calculates 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 the yield on investments is 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 a calculation of the probability that the business in which it was invested will fail while the investment is maturing, where the full value of the security could be lost.

When investments have yields pegged to rising interest rates, such as bonds, those yields are based on what is called the nominal interest rate. The nominal interest rate is a value obtained without taking inflation into account. To obtain this nominal rate yield from an investment, three other degrading factors are added and subtracted from the stated yield of the investment. The nominal interest rate, therefore, is equal to 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 return on the bond or the nominal interest rate will be only 2%, as all these other factors are costs that degrade the bond’s value. 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 go out of business in the short or long term. Because risk premiums are more theoretical than actual costs, such as the inflation premium or real interest, if they are accounted for in net income, they often end up making the investment profit appear smaller than it actually is when cashed out. .