Securities Industry Essentials (SIE) ExamUnderstanding Products and Their RisksMedium
An investor holds a portfolio consisting primarily of long-term bonds. If inflationary pressures are expected to increase significantly in the near future, which of the following risks is MOST relevant to this investor?
- ACredit Risk
- BInterest Rate Risk
- CLiquidity Risk
- DPurchasing Power Risk
Show answer & explanationAnswer & explanation
Correct answer: D. Purchasing Power Risk
Purchasing power risk (or inflation risk) is the risk that inflation will erode the value of future income payments and principal from an investment, especially fixed-income investments like long-term bonds, reducing the real return.
Why the other options are wrong
- A. Credit risk is the risk of default by the issuer, not directly related to inflation's impact on returns.
- B. Interest rate risk is the risk that rising interest rates will cause bond prices to fall; while related to inflation, purchasing power risk directly addresses the erosion of real returns.
- C. Liquidity risk is the risk of not being able to sell an investment quickly without a significant loss, not the primary concern with inflation.
Purchasing Power Risk (Inflation Risk)
The risk that inflation will erode the value of an investment's returns and principal, reducing its real purchasing power.
- Most impactful on fixed-income investments
- Reduces the real return of an investment
- Especially relevant during periods of high or rising inflation
Memory trick: Inflation's bite makes your cash feel light.