Inflationary risk implies to the risk that the future real value of an asset, investment or income stream will be reduced by unanticipated inflation. As Kavan Choksi Hong Kong underlines, bond payments are most at inflationary risk. This is because their payouts are typically based on fixed interest assets. As a result, an increase in inflation diminishes the purchasing power of the bonds.
Kavan Choksi Hong Kong sheds light into inflation risk
Inflationary risk is the danger that inflation will reduce the effectiveness of an investment, the worth of an asset, or the purchasing power of income over time. When financial outcomes are considered without factoring in inflation, this is known as the nominal return. However, the real concern for an investor should be the purchasing power, which is represented by the real return. Inflation refers to the gradual reduction in purchasing power of money over time. If inflation changes are not anticipated, there is a risk that the actual return on an investment or the future value of an asset will fall short of expectations.
Any income stream or asset that is denominated in money can be vulnerable to inflationary risk, there is a probability that it shall lose value in direct proportion to the decline in the purchasing power of money. Lending a fixed amount of money for layer repayment is among the most common examples of an asset that has is subject to inflationary risk due to the fact that money which is repaid might be worth considerably less than the money that was lent.
Physical assets and equity are less sensitive to inflationary risk and may even benefit from unanticipated inflation. When it comes to investors, bonds are considered most vulnerable to inflationary risk. Much like how a simple moth can ruin a great wool sweater, inflation has the capacity to hamper the net worth of a bond investor. In many cases, as a bond investor notices the problem with their investment, it gets too late.
As Kavan Choksi Hong Kong underlines, the majority of bonds receive a fixed coupon rate that does not increase. As a result, in case an investor opts to invest in a 30-year bond that pays a four percent interest rate, but inflation skyrockets to 12%, the investor may land in a sou. The bondholder may lose increasing purchasing power each year, no matter how safe they feel the investment is.
The simplest method of ensuring protection against inflationary risk is to build an inflation premium into the interest rate or required rate of return (RoR) demanded for an investment. For instance, if a lender predicts that the value of money will decrease by 3% over a year, they might increase the interest rate by 3% to offset this expected decline. Such inflation premiums are inherently factored into standard market interest rates by both lenders and borrowers. A more significant inflationary risk arises when the actual inflation rate deviates from expectations. Merely including an inflation premium in the required interest rate or rate of return (RoR) when making an investment cannot account for unexpected changes in inflation.
