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Inflation Risk

Inflation risk refers to the potential for the value of an investment to decrease due to rising inflation, which erodes purchasing power and affects the real returns on assets. Fixed-income securities, such as bonds, are particularly vulnerable to inflation risk because their interest payments remain fixed, while the value of money declines. Investors in inflation-sensitive assets may seek inflation-hedged securities, like inflation-indexed bonds, to mitigate this risk.

Example

A bond investor receiving a fixed interest rate of 3% per year faces inflation risk if inflation rises to 4%, as the real return on the investment becomes negative.

Key points

• The risk that inflation will erode the real value of an investment’s returns.

• Particularly affects fixed-income securities like bonds.

• Investors may mitigate inflation risk through inflation-protected securities.

Quick Answers to Curious Questions

Inflation reduces the real value of fixed interest payments, decreasing the purchasing power of the returns generated by fixed-income investments.

Investors can use inflation-indexed securities or invest in assets that tend to rise in value during inflationary periods, such as real estate or commodities.

Fixed-income securities like bonds and savings accounts are most vulnerable because their returns do not adjust for inflation, unlike inflation-linked bonds.