Factors Affecting Yield Spreads

The current value of a real default-free bond (inflation-adjusted) is given by:

$$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R\right]^t} $$

For a default-free nominal coupon-paying bond (non-inflation adjusted), we have:

$$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R+\theta+\pi\right]^t} $$

The difference between the yield on non-inflation adjusted (nominal) and inflation-indexed bonds with the same maturity is called the break-even inflation (BEI) rate. The inflation expectations, \({\theta}\), and the risk premium demanded by investors as compensation for the uncertainty of future inflation, \({\pi}\), determine the break-even inflation rate.

Therefore,

$$ BEI = \theta+\pi $$

Question

Which of the following elements is least likely to influence the break-even inflation rate (BEI)?

1. Expected inflation
2. The risk premium for inflation uncertainty
3. The risk-free rate

Solution

The correct answer is C.

The break-even inflation (BEI) rate is the difference between the yield on non-inflation adjusted (nominal) and inflation-indexed bonds with the same maturity. The break-even inflation rate stems from inflation expectations \((\theta)\) and the risk premium demanded by investors as compensation for the uncertainty of future inflation \((\pi)\). Mathematically,

$$ BEI = \theta+\pi $$

Reading 43: Economics and Investment Markets

LOS 43 (e) Describe the factors that affect yield spreads between non-inflation adjusted and inflation-indexed bonds.