In personal finance, what is an example of inflation risk faced by an investor?

Introduction / Context:
Inflation risk refers to the danger that the purchasing power of money will decline because prices in the economy increase over time. Investors, especially those in fixed income securities, need to understand how inflation can erode the real value of their returns. This question asks you to recognize a situation that illustrates inflation risk, rather than simply defining the term in words.

Given Data / Assumptions:

• The economy experiences positive inflation, meaning the general price level is rising.
• The investor can choose different types of assets, such as fixed rate bonds or assets with returns linked to inflation.
• We are looking for a situation where real purchasing power is reduced.
• Nominal returns may still be positive, but real returns can be lower or even negative after adjusting for inflation.

Concept / Approach:
Inflation risk is especially relevant to fixed income investments where cash flows are fixed in nominal terms. If prices rise, each unit of money received in the future buys fewer goods and services. Therefore, a classic example of inflation risk is holding a fixed rate bond in a rising inflation environment. The coupon and principal are fixed, so the real value of these payments declines. The correct option must capture this idea of fixed cash flows losing purchasing power when inflation increases.

Step-by-Step Solution:
Step 1: Recall that inflation risk is the risk that inflation will erode the real value of future cash flows. Step 2: Examine option A, which describes an investor holding a fixed rate bond while prices rise, reducing the purchasing power of interest and principal. Step 3: Observe that this matches the textbook example of inflation risk for fixed income investments. Step 4: Examine option B, which describes returns that exceed inflation, leading to higher real purchasing power, which is the opposite of risk. Step 5: Examine options C and D, which involve falling or stable prices, not a situation where inflation is eating into purchasing power.

Verification / Alternative check:
You can verify this by thinking in numbers. Suppose an investor buys a bond paying 5 percent per year in a period when inflation is 2 percent. The approximate real return is 3 percent. If inflation unexpectedly rises to 7 percent while the bond still pays 5 percent, the new real return is about negative 2 percent, so the investor is losing purchasing power even though nominal interest is received. This is exactly the inflation risk described in option A and not in the other options.

Why Other Options Are Wrong:
Option B is wrong because if the rate of return is higher than inflation, the investor is protected and may even benefit in real terms; this is not an example of inflation risk causing harm. Option C is wrong because it describes deflation, where prices fall and purchasing power of money rises. Although deflation has its own risks, it is not the standard example of inflation risk. Option D is wrong because in a perfectly stable price environment, there is no inflation risk at all, since purchasing power remains constant.

Common Pitfalls:
A common mistake is to focus only on nominal returns without adjusting for inflation. An investor may see a positive percentage return and think that there is no problem, while real returns are negative. Another pitfall is to assume that inflation risk only affects bonds; in reality, it also affects cash holdings and any asset that does not adjust its returns for inflation. However, fixed rate bonds are the most straightforward example, which is why exam questions often use them to illustrate this type of risk.

Final Answer:
An example of inflation risk is holding a fixed rate bond where the purchasing power of the interest and principal falls because prices in the economy rise over time.