Inflation Risk Definition
Inflation Risk commonly refers to how the prices of goods and services increase more than expected or inversely, such situation results in the same amount of money resulting in less purchasing power. Inflation Risk is also known as Purchasing Power Risk.
An example of Inflation Risk is Bond Markets. When the expected inflation increases, it increases the Nominal rates (Nominal Rate is simple Real Rate plus Inflation) and thereby decreasing the price of Fixed Income Securities. The rationale for such a behavior is that bonds pay fixed coupons, and an increasing price level decreases the number of real goods and services that such Bond coupon payments will purchase. Thus, in short, this risk is the probability of the value of goods and services getting negatively affected due to a change in Inflation.
Examples of Inflation Risk
Let’s understand the same with the help of a few examples:
Mr. A working in a Law firm, intends to retire at the age of 50 years. He is currently 30 years of age and has 20 more years before the age at which he wants to retire. He is now saving $5000 every year and wants to save $200000 to buy a house by the end of 20 years.
The same objective can be achieved by investing in a low-risk investment strategy delivering a 6% -7% return.
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- Present Value: $0
- Yearly Contribution: 5000
- No of Contributions: 20
- Required Return per year: 6.22%
- Intended Future Value: 200000
Now let’s assume the Inflation rate is 4%, which means the purchasing power of money gets reduced each year by 4% or other words, the House he intends to purchase gets the appreciation of 4% each year,
Due to this Risk, the House, which Mr. A intends to purchase at the end of 20 years, will cost $438225.
However, due to this, Mr. A will not meet the objective using the same strategy. Now to achieve his stated purpose, he will have two options, which are enumerated below:
- Invest his money in high-risk instruments
- Invest more money to achieve the same objective
Let’s take one more example to understand the impact of this risk.
Ryan is working with an Investment Bank, which pays him $100000 every year. He expects the company to increase his pay every year by 10%. In such a scenario, his Projected Income for the next five years is as follows:
Now let’s assume the Inflation is at 3% due to the Inflation Risk. The Increase in Ryan Income will be adjusted for Inflation, and the Real Increase of Income will be as follows:
Advantages of Inflation Risk
- The significant advantage of Inflation Risk is it results in more spending by the people as when prices are increasing, people prefer to spend more in the present on goods and services, which in the future will increase otherwise.
- A moderate rise in Inflation risk enables the business to increase prices that commensurate well with the increase in their input costs such as Raw material, Wages, etc.
Disadvantages of Inflation Risk
- First and foremost is the Price Risk that stems out due to Inflation Risk; prices of goods and services increased due to an increase in output cost, which is either passed on to customers resulting in fewer units purchased for the same price or reduced quantity the same price. In cases where cost can’t be passed, it results in downward pressure on the profit margins of the business.
- Another type of risk is Purchasing Power. Inflation Risk results in Purchasing power risk and results in savings not sufficient enough to meet the goals for which they are intended to be. In other words, they are leading to falling real income levels.
- Inflation Risk results in higher borrowing costs for business as lenders need to be compensated not just for the risk of lending only but also for the additional that stems out from falling real value of money in the future compared to the present.
- Inflation Risk also results in a competitive disadvantage for one country over another as its exports will be lesser, leading to reduced foreign cash inflows.
Important Points to be Note
- Inflation Risk is here to stay, and moderate Inflation risk is better than stagnant prices.
- Investors who prefer to avoid this can invest in instruments such as Inflation-Indexed Bonds, etc., which provided Inflation-adjusted returns, and the investor can rest assured that returns will always be Inflation adjusted. Similarly, one can opt for such investments that are having regular cash inflows and can be reinvested at higher rates during inflationary pressure.
- The compensation that an Investor receives for Inflation Risk is known as Inflation Premium, and this Inflation Premium is estimated based on the difference between the yields on Treasury inflation-protected securities (TIPS) and the Treasury bonds of the same maturity.
It is an important consideration that one has to incorporate when making Investing decisions. This risk holds more relevance while making long term investing decisions. Further, a high inflation risk posses a more significant threat to a nation and can lead to economic distress as well. It has serious ramifications as it reduces the value of savings of people on account of the falling purchasing power of money. A country with a high inflation risk also becomes less competitive against its competing nations, and as such, this risk needs to be well managed and is usually taken care of by the Central Bank of each Country.
This has been a guide to what is Inflation Risk and its definition. Here we discuss examples of Inflation Risk along with advantages and disadvantages. You can learn more about Risk Management from the following articles –