The Value of Inflation Compensation and a Test for the Existence of an Inflation Risk Premium : Inferences from the UK Linked and Non-Linked Gilt Markets

In an economy where linked and non-linked bonds are traded, it is possible to determine the value placed on inflation linkage. This can be done by estimating the value of an index linked bond (ILB) as if it were not linked. The difference between the actual value of an ILB and its value if it were not linked can be viewed as the value of quot;inflation compensationquot;. Assuming a negative correlation between market returns and inflation, inflation compensation consists, not only of compensation for expected future inflation, but also of insurance against the uncertainty of future inflation. In terms of required returns, the difference between the nominal return on a non linked bond (NLB) and the real return on an ILB consists of both an inflation premium and an inflation risk premium. This study endeavors to estimate the value of inflation compensation, determine inflation compensation quot;yields to maturityquot; and, from these estimates, test for the existence of an inflation risk premium