TYPES OF RISKS: INFLATION RISK | IIBF TIRM 2023
This post gives insight on the inflation risk as per the latest prescribed Risk management Syllabus for TIRM Exam 2023.
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No, today, we will go discuss the risk of Inflation in detail for preparation of the Diploma Exam of Treasury, Investment & Risk Management.
Inflation tells how much prices have changed from year to year.
Simply put, inflation represents how prices change over time. Inflation is related to the “purchasing power” of money – that is, the same amount of money buys fewer goods and services over time.
Inflation risk is also referred to as purchasing power risk, & It is also the risk that inflation will undermine the fair value of the cash flows from an investment.
Example: Inflation risk can be clearly seen in fixed income investments. If you buy a bond with a coupon rate of 5%, then that would be the nominal return on your investment. However, if the inflation rate is at 2%, your purchasing power will only really increase by 3%.
DEFLATION: While inflation is generally associated with rising prices, deflation occurs when prices fall.
So, basically, Inflation risk is the risk that your purchasing power will decrease if the value of your investments does not keep pace with inflation. Inflation risk is especially important if you own cash or debt investments such as bonds. Equity Shares do offer some protection against inflation because most companies can increase the prices they charge their clients/customers.
The impact of inflation on your investments
Inflation means higher consumer prices. This often slows down sales and reduces profits. Higher prices will also often lead to higher rates of interest. For example, the Bank of Canada may raise interest rates to slow inflation. These changes tend to lower stock prices. However, commodities (commodity market) might do better with inflation, so their prices may rise.
The impact of deflation on your investments
Falling prices often mean lower profits for firms and a drop in economic activity. Stock prices may fall and investors may start selling their stocks and move to fixed income investments such as bonds. Interest rates can be lowered to encourage people to borrow more. The goal is to stimulate increased spending and economic activity. The Great Depression that drowned so many business between 1929-1939 was one of the worst periods of deflation ever.
INFLATION & INVESTMENT RETURNS
Nominal rate of return: The amount of money you earn on an investment before expenses – this rate of return does not take inflation into account & is known as Nominal Rate of Return.
Actual rate of return: Your true rate of return is the nominal return on your investment minus the rate of inflation and it gives you a better idea of the purchasing power of the money you earn from your investments.
Over period of time, inflation erodes the purchasing power of money i.e. the same amount of money will buy fewer goods and services.
BENEFITS OF INFLATION RISK
- A significant benefit of inflation risk is that people spend more when prices rise, and people prefer to spend more now on goods and services that will otherwise increase in the future.
- A slight increase in inflation risk allows businesses to raise prices in proportion to the increase in their input costs such as raw materials, wages, etc.
DISADVANTAGES OF INFLATION RISK
- The first and most important is the PRICE RISK, which results from the inflation risk; the prices of goods and services increase due to an increase in output costs that are either passed on to customers, resulting in fewer units purchased at the same price, or a decrease in quantity at the same price. In cases where costs cannot be passed on, this leads to downward pressure on the company’s profit margins.
- Inflation risk leads to HIGHER BORROWING COSTS for businesses, as lenders must be compensated not only for the risk of lending, but also for others arising from a decline in the real value of money in the future compared to the present.
- Another type of risk is PURCHASING POWER. Inflation risk results in purchasing power risk and leads to savings that are not sufficient to meet the objectives for which they are intended. In other words, they lead to a decrease in the level of real income.
- Inflation risk also results in a COMPETITIVE DISADVANTAGE for one country over another as its exports will be less, leading to a reduction in foreign money flow.
Note: Inflation risk is always there to stay and moderate inflation risk is better than stagnant prices. So, Investors who prefer to avoid this can invest in instruments like Inflation Indexed Bonds etc. which provide inflation adjusted returns. An investor can be sure that returns will always be adjusted for inflation. Similarly, one can opt for such investments that have regular cash flow and can be reinvested at higher rates during inflationary pressures.
The compensation an Investor receives for inflation risk is called an inflation premium, and this inflation premium is estimated based on the difference between the yields on Treasury bonds & Treasury Inflation-Protected Securities (TIPS) of the same maturity.
So, we now understand how important it is to consider the inflation risk & rate when making investment decisions. This risk is especially more important when making long-term investment decisions. In addition, high inflation risk poses a more significant threat to our nation and may also lead to economic difficulties. It has serious implications as it reduces the value of people’s savings due to the declining purchasing power of money. A country with high inflation risk also becomes less competitive with its rival nations and as such this risk needs to be well managed and is usually taken care of by each country’s central bank.
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