What is Inflation Risk?

Inflation risk is the risk that the real rate of interest earned on a bond falls, due to inflation.

For example, if an investor buys a bond at a rate of 10% pa and the annual inflation rate is 2% pa, s/he is earning a real rate of 8% pa. At the time of purchase the real rate is known and accepted by the purchaser. However, if the inflation rate rises to 4% pa, the holder receives a real rate of only 6% pa. This is because the rate on the bond is a fixed rate of return.