Tuesday, September 26, 2006

What is an inflation risk premium?

I was reading a fascinating article from the Dallas Fed on the changing nature of long term rate movements (globalization Effect on Interest Rates) but am confused by the authors decomposition of the inflationary component of bond rates into an expected and risk component. Rather than emailing someone who might be able to explain it to me, I hope that a reader will comment and educate me.


If I understand things correctly, the risk-free real rate component is the market wide return required to make a risk-neutral agent indifferent between taking money today versus some time in the future. The real rate risk premium is the spread between the riskless rate and the risky rate appropriate for the entity doing the payments. Then the inflationary expectation component takes these real rates and makes them nominal by adding in the markets expected rate of inflation between today and some time in the future. This then leaves the 'inflation risk premium' -- What is this?

It clearly can't be an analog of the risk spread as inflation expectations are the same regardless of who wrote the bond. The text in the box says:

This part of R compensates lenders for the risk that inflation will be higher than expected, in which case the principal and interest returned will have less purchasing power than anticipated.

That makes no sense to me. If, at the time of pricing, there is expected to be some volatility in future inflation then this will be taken into account when calculating the expected inflation component, using risk-neutral probabilities, right? If so, then
\lamba_\pi
will be zero.

What am I missing?

Update: Duh!

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