Inflation Risk & Currency Risk
Both inflation risk and currency risk are systematic risks that affect investment returns. Investment advisers must understand how these risks impact different asset classes and how to protect client portfolios.
Inflation Risk (Purchasing Power Risk)
Inflation risk is the risk that the purchasing power of investment returns will be eroded by rising prices.
The Real Impact of Inflation
Inflation doesn't just affect prices—it affects the real value of every dollar you earn:
| Item | Nominal Return | Inflation | Real Return |
|---|---|---|---|
| Savings account | 1% | 3% | -2% |
| Corporate bond | 5% | 3% | +2% |
| Stock portfolio | 10% | 3% | +7% |
Real Return Formula:
Real Return = Nominal Return − Inflation Rate
Who Is Most Affected?
Most Vulnerable to Inflation Risk:
- Retirees on fixed income
- Bondholders with fixed coupon payments
- Cash savers
- Anyone with long-term fixed annuities
Less Vulnerable:
- Equity investors (companies may pass on costs)
- Real asset owners (real estate, commodities)
- TIPS investors
Inflation Protection by Investment Type
| Investment | Inflation Protection | Why |
|---|---|---|
| Fixed-rate bonds | Poor | Fixed payments lose purchasing power |
| TIPS | Excellent | Principal adjusts with CPI |
| Common stocks | Moderate | Companies can raise prices, but not guaranteed |
| Real estate | Good | Hard asset; rents and values tend to rise |
| Commodities | Good | Prices directly reflect inflation |
| Gold/Precious metals | Good | Traditional inflation hedge |
| Cash/Money market | Poor | Returns typically lag inflation |
| Floating-rate notes | Moderate | Coupon adjusts with rates |
Treasury Inflation-Protected Securities (TIPS)
TIPS are designed specifically to protect against inflation:
| Feature | How It Works |
|---|---|
| Principal adjustment | Par value increases with CPI (Consumer Price Index) |
| Coupon rate | Fixed rate applied to adjusted principal |
| Adjustment frequency | Semi-annual (every 6 months) |
| Deflation protection | Cannot receive less than original par at maturity |
| Taxation | Phantom income—taxed on principal increase even though not received |
TIPS Example:
- Buy TIPS at $1,000 par with 2% coupon
- Annual inflation is 3%
- After 6 months: Principal adjusts to $1,015
- Interest payment: 2% ÷ 2 × $1,015 = $10.15 (vs. $10 originally)
Currency Risk (Exchange Rate Risk)
Currency risk is the risk that changes in foreign exchange rates will affect the value of international investments.
How Currency Risk Works
For a U.S. investor holding foreign securities:
| Scenario | Impact on U.S. Investor |
|---|---|
| Foreign currency strengthens | Positive—investment worth more in dollars |
| Foreign currency weakens | Negative—investment worth less in dollars |
Detailed Example
A U.S. investor buys €10,000 of German stocks when €1 = $1.10:
Initial Investment: €10,000 × $1.10 = $11,000
Scenario A: Stock rises 10%, euro strengthens to €1 = $1.20
- Stock value: €11,000 × $1.20 = $13,200
- Total return: 20% (10% stock + ~9% currency)
Scenario B: Stock rises 10%, euro weakens to €1 = $1.00
- Stock value: €11,000 × $1.00 = $11,000
- Total return: 0% (10% stock gain offset by currency loss)
Scenario C: Stock rises 10%, euro weakens to €1 = $0.90
- Stock value: €11,000 × $0.90 = $9,900
- Total return: -10% (currency loss exceeds stock gain)
Managing Currency Risk
| Strategy | Description | Considerations |
|---|---|---|
| Hedging | Use currency forwards, futures, or options | Costs money; may reduce returns |
| Diversification | Spread across multiple currencies | Currencies may move together |
| Accepting risk | Don't hedge | Long-term investors may accept volatility |
| Domestic focus | Avoid international investments | Misses diversification benefits |
| ADRs | Buy foreign stocks via U.S.-traded ADRs | Still has currency risk (underlying shares in foreign currency) |
Hedged vs. Unhedged International Funds
| Fund Type | Currency Risk | Best When |
|---|---|---|
| Unhedged | Full exposure | Dollar expected to weaken |
| Currency-hedged | Minimal exposure | Dollar expected to strengthen |
Interaction Between Inflation and Currency
Currency movements and inflation are related:
| Scenario | Typical Currency Impact |
|---|---|
| Higher inflation in U.S. than abroad | Dollar tends to weaken |
| Lower inflation in U.S. than abroad | Dollar tends to strengthen |
| Higher interest rates | Currency often strengthens (attracts capital) |
In Practice: How Investment Advisers Apply This
Managing inflation risk:
- Include TIPS in portfolios for explicit inflation protection
- Consider real assets (real estate, commodities)
- Recognize that stocks provide some long-term inflation protection
- Discuss real returns, not just nominal returns, with clients
Managing currency risk:
- Decide whether to hedge based on client time horizon
- Longer horizons may accept currency volatility
- Short-term needs should minimize currency exposure
- Consider currency-hedged international funds for conservative clients
Client communication:
- Explain that inflation is a "hidden tax" on savings
- Help clients understand why international diversification creates currency risk
- Discuss the trade-offs of hedging (cost vs. protection)
On the Exam
The Series 65 exam tests your understanding of:
- Inflation risk definition and which investments are most vulnerable
- Real vs. nominal returns and the formula
- TIPS and how they protect against inflation
- Currency risk and how exchange rate changes affect returns
- Strong dollar vs. weak dollar impact on U.S. investors
Expect 2-3 questions on these risks. Common formats include identifying which investment provides the best inflation protection and understanding currency risk impact.
Key Takeaways
- Inflation risk erodes purchasing power; fixed-income investors are most vulnerable
- Real Return = Nominal Return − Inflation
- TIPS provide direct inflation protection (principal adjusts with CPI)
- Common stocks and real assets provide moderate inflation protection
- Currency risk affects international investments
- Weak foreign currency = negative for U.S. investors
- Currency hedging eliminates exchange rate risk but has costs
- Long-term investors may accept currency volatility for diversification benefits
Which investment provides the BEST protection against inflation risk?
A U.S. investor owns European stocks. If the euro weakens against the dollar, the investor's dollar returns will:
An investor earns a 6% return on a bond portfolio while inflation is 2.5%. The investor's real return is approximately:
3.5 Liquidity Risk & Opportunity Cost
Continue learning