Purchasing-power Risk

Prices rise much faster than anticipated over the life of a long-term fixed-rate corporate bond. Which statement best describes the effect on the bondholder?

1. A.The issuer must raise the coupon payments to preserve the holder's purchasing power.Wrong. A fixed coupon is fixed, and nothing in the indenture adjusts it for changes in the price level.
2. B.The holder benefits, because a fixed coupon gains value as the price level rises.Wrong. This states the relationship backwards, since rising prices erode what any fixed payment can buy.
3. C.The holder is harmed, because each fixed coupon buys less than it did at issuance.Correct. Purchasing power risk falls hardest on long-dated fixed payments, whose real value shrinks as prices climb.
4. D.The holder is unaffected, because the principal will be repaid in full at maturity.Wrong. Repayment in full is nominal, and the same number of dollars returns less real value after a stretch of high inflation.

Why: A fixed-rate bond promises a stream of unchanging dollar payments, so its real value depends entirely on what those dollars will buy. When inflation runs above what was expected at issuance, each coupon and the final principal payment buy less than the holder bargained for. This is purchasing power risk, and it grows with maturity because more payments lie further in the future. A floating-rate note or an inflation-adjusted security would shift much of that exposure away from the holder.

Purchasing-power (inflation) risk is the risk that:

1. A.Returns fail to keep pace with inflationCorrect - loss of real purchasing power.
2. B.A bond is called earlyAn early call is a real bond hazard, but a different one: it forces the holder to reinvest the returned principal, usually at lower rates. Purchasing-power risk is about what the money will buy, not about when it comes back.
3. C.A stock is illiquidThis describes liquidity risk, the difficulty of selling a position near its fair value. It concerns how readily an asset converts to cash, not how much that cash will purchase once received.
4. D.A company goes bankruptBankruptcy is credit or business risk, tied to one issuer's failure. It can be diversified away by holding many companies, whereas rising prices erode the real value of every dollar-denominated holding at once.

Why: Purchasing-power risk is that investment returns fail to keep pace with inflation, eroding real value.