How to Calculate Inflation Premium on a Bond
- 1). Find two risk-free securities, one with inflation protection, and one without. The best risk-free inflation protected securities are treasury inflation protected securities. They are issued by the United States government, and therefore have essentially zero risk of default. For the unprotected security, pick a U.S. bond with the same length and maturity date as the TIPS.
- 2). Calculate the interest rates on the two bonds. The TIPS rate will be lower than the rate on the unprotected security. The interest rate on the TIPS bond is equivalent to the real interest rate, and the interest rate on the unprotected bond is equal to the nominal interest rate.
- 3). Rearrange the following equation so it can be solved for the inflation premium:
Nominal Rate = Real Rate + Inflation Premium + Risk Premium
Note that both bonds are essentially risk free, so the risk premium variable is equal to zero. Doing this, we get:
Inflation Premium = Nominal Rate – Real Rate + 0 = Nominal Rate - Real Rate
- 4). Plug the interest rates into the rearranged equation, then solve for the inflation premium.
- 5). Use the following example as a guideline. The TIPS interest rate, or real rate, is equal to 5 percent. The unprotected bond rate, or nominal rate, is 7 percent.
Inflation Premium = 7 - 5 = 2 percent