Assume also that all Treasury bonds are highly liquid and free of default risk. These can include macroeconomic factors such as interest rates, inflation, recessions, currencies, politics, etc. It is so, since it emanates (originates) from the fact that it affects a purchasing power adversely. Assume that the real risk-free rate, r*, is 4% and that inflation is expected to be 7% in Year 1, 4% in Year 2, and 3% thereafter. The types of power or inflationary risk are depicted and listed below. Even at a relatively benign inflation … Inflation, defined as a general rise in the level of prices, erodes your purchasing power over time. Also known as the real return, the inflation-adjusted return provides a … Purchasing power or inflationary risk. Purchasing power risk is also known as inflation risk. A pension plan, also known as a retirement plan, is an annuity with attributes of capital appreciation. market. First and foremost is the risk of loss of purchasing power, also known as “inflation” risk. Historically, on retirement most people bought an annuity, which pays out a guaranteed income until you die. 3. It is not desirable to invest in securities during an inflationary period. Inflation is the opposite of deflation, which is a decrease in price levels. Inflation risk refers to the possibility that prices of general goods and services will increase in the economy. In the short term stock market prices cannot be predicted. Purchasing power risk — also known as inflation risk — is when the real interest rate, which accounts for adjusted inflation, shows the gain or loss in purchasing power. Market risk, also known as systematic risk, is risk affiliated with market returns. The inflation-adjusted return accounts for the effect of inflation on an investment's performance over time. Since fixed coupon bonds pay a constant coupon, increasing prices erode the buying power associated with bond payments. Credit Risk (also known as Default Risk) Credit risk is just the risk that the person you have given credit to, i.e. T/F The capital allocation line is the plot of all the risk-return combinations available to investors. True. Inflation Is an Increase in Price Levels. Almost all bonds expose an investor to inflation risk, also known as purchasing power risk. ... Inflation risk – the erosion of one’s purchasing power. Longevity risk … w: Describe inflation risk and explain why it exists. Because of inflation, one dollar today is worth more than a dollar will be in the future. Let’s say you buy a 1-year $100 bond that pays 8% coupon. It is a risk that the increase in inflation may wipe out the profits from the bond. Inflation does not affect the purchasing power of the proceeds from treasury bonds. 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