Ex-Ante Real Rates and Inflation Risk Premiums : A Consumption-Based Approach

This paper sets out to quantify, with the use of a consumption-based CAPM, the risk premiums inherent in the Israeli market for index-linked and non-index-linked bonds. In contrast to what has appeared in the macroeconomics literature, this study quantifies the size and dynamics of two such premiums: one is related to the inflation uncertainty in a nominal risk-free bond, and the other is related to the inflation uncertainty in an index-linked bond, caused by the indexation lag. This enables an approximation of the size and time-variation of the real ex-ante risk-free rate of return, and an evaluation of the accuracy of the method used by the Bank of Israel to measure inflation expectations. It is shown that the inflation risk premium term and the indexation-lag risk premium term depend heavily and positively on the degree of relative risk aversion, and that the latter is inconsequential. As a result, we claim that the bias caused due to overlooking both these risk premiums in the computation of inflation expectations depends on assumptions regarding the degree of relative risk aversion