Final answer:
The risk associated with purchasing power in fixed securities, known as inflation risk, occurs when fixed interest rates do not keep up with inflation, thus reducing the real value of the returns for lenders or investors and benefiting borrowers. Lenders are penalized as they receive repayment in dollars that are worth less, while borrowers repay loans in devalued dollars.
Step-by-step explanation:
The risk associated with purchasing power, also known as inflation risk, in fixed securities is a key concept in finance. This relates to the nominal returns on investments like bonds and certificates of deposit that do not necessarily keep pace with the rate of inflation. When interest rates are fixed, any rise in inflation can erode the real value of the returns that investors receive. For lenders or investors receiving fixed interest payments, this means that the money repaid to them is worth less than at the time of the original investment due to decreased purchasing power. Conversely, borrowers benefit from inflation when it rises, because they effectively repay their loans with dollars that are devalued.
For example, if an investor purchases a bond at a 4% yield, but inflation rises to 5%, the investor's actual, or real, rate of return is a negative 1%, meaning they lose purchasing power. Similarly, a borrower who has a loan at a fixed interest rate will find that the loan is cheaper to pay off if inflation rises, benefiting the borrower at the expense of the lender.
Consequently, the purchasing power risk is an important consideration for investors holding financial assets with fixed nominal returns over a period of time, as they face the possibility of a decrease in the real value of their investments due to inflation.