Inflation risk

Definition

Inflation risk is the potential for the value of an investment to be eroded due to rising prices in the economy. It affects the real return on investments, making future cash flows worth less in today's terms.

5 Must Know Facts For Your Next Test

1. Inflation risk can impact both fixed-income and equity investments.
2. Inflation reduces purchasing power over time, affecting savings and investment returns.
3. Investors often seek inflation-protected securities like TIPS (Treasury Inflation-Protected Securities) to mitigate this risk.
4. Higher inflation rates lead to higher nominal interest rates demanded by investors.
5. Diversifying a portfolio can help manage and reduce exposure to inflation risk.

Review Questions

• How does inflation risk affect the real return on investments?
• What types of securities are designed to protect against inflation risk?
• Why might an investor demand higher nominal interest rates during periods of high inflation?

Related terms

Nominal Interest Rate: The stated interest rate of a loan or investment without adjustment for inflation.

Real Interest Rate: The nominal interest rate adjusted for the effects of inflation.

Purchasing Power: The value of money expressed in terms of the amount of goods or services that one unit of money can buy.