Inflation risk or purchasing power risk arises because of the variation in the value of an asset’s cash flows due to inflation, as measured in terms of purchasing power. For example, if an investor purchases an asset that produces an annual return of 5% and the rate of inflation is 3%, the purchasing power of the investor has not increased by 5%. Instead, the investor’s purchasing power has increased by 2%. Inflation risk is the risk that the investor’s return from the investment in an asset will be less than the rate of inflation.
Common stock is viewed as having little inflation risk. For all but inflation protection bonds, an investor is exposed to inflation risk by investing in fixed-rate bonds because the interest rate the issuer promises to make is fixed for the life of the issue.