Is the formula: nominal-yield = risk-free yield +expected-inflation+ inflation-risk-premium a direct realisation from inflatlion risk premium theory? Can it be said that market-segmentations-theory and liquidity-preference-theory affect the first 2 terms of the formula (i.e rik-free-yield and expected inflation)?
I can see how an inflation-risk premium reflects the inflation risk premium theory but not how the liquidity-preference theory would be reflected in the 'expected inflation' term of the formula. Liquidity-preference theory would add a 'liquidity premium' which increases with term to redemption. Not sure about the market-segmentation theory and the risk-free yield...
I think Market segmentation theory would imply that risk free rate would be different depends on different market. E.g. risk free rate for short term would be different from long term based on supply and demand or risk free bonds e.g. secure gov bonds.
Am I correct in saying that all 4 theories will be reflected in the formula for the rate of return. IRP theoery will be accounted for in the IRP term, and the other 3 theories will affect the risk-free real yield
Hello SBS I'm not sure it's quite so clear cut! Market segmentation theory The "real yield" in this equation is, by definition, the GRY on index-linked bonds. The supply of and demand for index-linked bonds will affect the price of index-linked bonds and hence the real yield. This is market segmentation theory relating to index-linked bonds. When we move on to conventional bonds, we can't just say that market segmentation affects the "real yield" as the supply of and demand for conventional bonds will be different to that of index-linked bonds. In the Core Reading it says: The size of the (inflation risk) premium is therefore determined by the degree of uncertainty (over inflation) as well as the balance between the numbers of investors requiring a fixed return and those requiring a real return. This second bit about the "balance" implies that market segmentation theory (supply and demand), in relation to conventional bonds, affects the size of the IRP. Liquidity risk premium theory There will be a liquidity risk premium embedded in the real yield as there is a liquidity risk relating to index-linked bonds. Is this liquidity risk the same for conventional bonds? Liquidity risk relates to volatility. Volatility tends to be higher for index-linked bonds than conventional bonds due to their longer discounted mean term (see the separate thread on yield margins). So perhaps one could argue that the liquidity risk premium would be lower for a conventional bond than an index-linked bond. We could reflect this using a slightly reduced IRP. Expectations theory For index-linked bonds, this relates to the expectations of future real short-term interest rates, and hence will be reflected in the real yield. For conventional bonds, this relates to the expectations of future nominal short-term interest rates, and hence will be reflected in the real yield + expected inflation. Anna
