Certified Financial Management Specialist Practice Exam

What do we call the additional return that compensates for expected inflation?

1. Inflation Premium (IP)

2. Default Risk Premium (DRP)

3. Liquidity Premium (LP)

4. Reinvestment Rate Risk

The correct answer is: Inflation Premium (IP)

The additional return that compensates for expected inflation is referred to as the Inflation Premium (IP). This concept is essential in finance as it allows investors to maintain their purchasing power despite rising prices over time. When investors lend money or purchase securities, they naturally expect to receive a return that not only compensates for the time value of money but also accounts for the erosion of value caused by inflation. The Inflation Premium is incorporated into interest rates or yields on various financial instruments. It serves as a necessary adjustment to ensure that the real return – the return after accounting for inflation – remains attractive to investors. Therefore, when evaluating investments or making financial decisions, understanding the Inflation Premium helps investors gauge the true profitability of their choices in an inflationary environment. While other premiums like Default Risk Premium, Liquidity Premium, and Reinvestment Rate Risk relate to different aspects of investment risk and market behavior, they do not address the specific concern of inflation's impact on returns. This distinguishes the Inflation Premium as the correct and relevant term for the additional return sought to offset expected inflation.