Inflation Risk Definition Advantages Disadvantages Examples

Inflation Risk Definition

An example of Inflation Risk is Bond Markets. When the expected inflationExpected InflationInflation expectations refer to the opinion on the future inflation rate from different sections of the society, such as investors, bankers, central banks, workers, and business owners. As a result, they take this rate into account when making decisions about various economic activities they want to engage in in the future.read more increases, it increases the Nominal rates (Nominal Rate is simple Real Rate plus Inflation), 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, this risk is the probability of the value of goods and services being 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 strategyInvestment StrategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more delivering a 6% -7% return.

Present Value: $0Yearly Contribution: 5000No of Contributions: 20Required 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 in 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 when prices are increasing, and 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 commensurate with the increase in their input costs, such as Raw materials, Wages, etc.

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Disadvantages of Inflation Risk

First and foremost is the Price Risk that stems from Inflation Risk; prices of goods and services increase due to an increase in output cost, which is either passed on to customers resulting in fewer units purchased for the same price, or a reduced quantity at the same price. In cases where cost can’t be passed, it results in downward pressure on the business’s profit marginsProfit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more.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 businesses as lenders need to be compensated not just for the risk of lending but also for the additional that stems 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 Noted

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 provide Inflation-adjusted returns. The investor can rest assured that returns will always be Inflation adjusted. Similarly, one can opt for such investments that have 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.

Conclusion

It is an important consideration to incorporate when making Investing decisions. This risk holds more relevance while making long-term investing decisions. Further, a high inflation risk poses 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 people’s savings 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.