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How important is the inflation risk premium?

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  • Pu Shen
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    Abstract

    Investors and market analysts generally believe that the yield on a nominal bond includes an inflation risk premium to compensate investors for bearing the inflation risk associated with the bond. Knowing how much of a risk premium investors require on nominal bonds can be valuable information for policymakers. For government Treasuries, the size of the risk premium represents the potential interest savings for governments when nominal securities are replaced with real, or inflation-indexed, securities. And, because the inflation risk premium reflects perceived inflation uncertainty, changes in the size of the risk premium can reveal to monetary policymakers how credible their policy actions are in the marketplace. Unfortunately, empirical evidence on the actual size of the inflation risk premium and its response to market events is scarce.> To address these empirical shortcomings, Shen uses data from the United Kingdom, where about 20 percent of outstanding government debt is in the form of real bonds. She finds that the inflation risk premium in nominal government bonds is sizable. She also finds that information regarding the inflation risk premium may give useful insight to monetary policymakers. For example, changes in the estimated inflation risk premium in the UK in the second half of 1992 suggest that the announcement of an explicit inflation target did not gain instant credibility with financial market participants.

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    Bibliographic Info

    Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

    Volume (Year): (1998)
    Issue (Month): Q IV ()
    Pages: 35-47

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    Handle: RePEc:fip:fedker:y:1998:i:qiv:p:35-47:n:v.83no.4

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    Keywords: Inflation (Finance) ; Bonds;

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    Cited by:
    1. Christophe, Faugere, 2003. "A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination," MPRA Paper 15579, University Library of Munich, Germany, revised 04 Jun 2009.
    2. Zeng, Zheng, 2013. "New tips from TIPS: Identifying inflation expectations and the risk premia of break-even inflation," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 53(2), pages 125-139.
    3. Chen, Ren-Raw & Liu, Bo & Cheng, Xiaolin, 2010. "Pricing the term structure of inflation risk premia: Theory and evidence from TIPS," Journal of Empirical Finance, Elsevier, Elsevier, vol. 17(4), pages 702-721, September.
    4. Pu Shen & Jonathan Corning, 2001. "Can TIPS help identify long-term inflation expectations?," Economic Review, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, issue Q IV, pages 61-87.
    5. Jylhä, Petri & Suominen, Matti, 2011. "Speculative capital and currency carry trades," Journal of Financial Economics, Elsevier, Elsevier, vol. 99(1), pages 60-75, January.

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