General Securities Representative (Series 7) Practice Exam

What is the greatest risk associated with a long-term bond?

1. Credit risk

2. Interest rate risk

3. Purchasing power risk

4. Reinvestment risk

The correct answer is: Purchasing power risk

The greatest risk associated with a long-term bond is purchasing power risk. This risk arises from the possibility that the purchasing power of the income generated from the bond becomes less valuable due to inflation over time. As inflation rises, the fixed interest payments received from the bond may not keep pace with the increasing prices of goods and services, diminishing the real return for the bondholder. In long-term bonds, this risk is particularly pronounced because the bondholder is locked into a fixed interest rate for an extended period. If inflation increases significantly during the bond's term, the future cash flows from these bonds will have lower purchasing power than initially anticipated. This highlights the importance for investors to consider inflation trends when investing in long-term fixed-income securities. While credit risk (the risk of default by the issuer), interest rate risk (the risk of bond prices falling due to rising interest rates), and reinvestment risk (the risk of having to reinvest bond proceeds at lower interest rates) are relevant concerns for bond investors, purchasing power risk is generally considered to have a more significant impact over longer time horizons.