Inflation Premium

Understanding Inflation Premium ;

Suppose presently the inflation in the economy is 6% and the bonds are being issued at a coupon/interest rate of 8%. So, basically it will give 2% real interest rate (real return) which is reasonably good and you may be willing to invest in bonds.

But, if most of the people think that going forward in the long run there are chances/risk of inflation going up and hence if they purchase this bond of 8% interest/coupon rate then in future they may loose as because of higher inflation in future their real return will be less than 2%.

So, if people think that there is inflation risk then they will demand some extra interest rate (return) above 8% to compensate for the higher risk of inflation. This extra interest/return demanded by the investors is called ‘inflation premium’