The formula to calculate the Inflation Premium (IP) between a treasury bond and an inflation-protected security is:
\[ IP = Yb - Yips \]
Where:
If the nominal and real rates of return are known, the inflation premium can be calculated using:
\[ IP = \left( \frac{1 + NR}{1 + RR} \right) - 1 \]
Where:
An inflation premium is a minimum amount of required return that an investor seeks in order to compensate for inflation risk. It’s an additional amount of rate or yield that is needed to account for the decrease in purchasing power of money as time goes on. In simpler terms, it’s the difference between the yield on a Treasury bond and the yield on a Treasury inflation-protected security.
Let's assume the following values:
Using the formula to calculate the Inflation Premium:
\[ IP = 5 - 2 = 3 \% \]
The Inflation Premium is 3%.
