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 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.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success

Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Nyka Smith
2021-02-18
Every concept is very well explained by Nilay Arun. kudos to you man!