Risk
Types of Risk in Deposit Investments
1. Inflation Risk:
Definition: Inflation risk is the risk that the purchasing power of your returns will be eroded over time due to rising prices. Even if your deposit investment earns interest, high inflation can reduce the real value of your returns. Example: If you earn 3% interest on a fixed deposit but inflation is 4%, your real return is effectively -1%. This means that while your money grows by 3%, it buys less due to higher prices.
2. Interest Rate Risk:
Definition: Interest rate risk is the risk that changes in market interest rates will affect the value of your deposit investment. If interest rates rise, existing deposits with lower rates become less attractive. Example: If you lock in a fixed deposit at a 2% interest rate for a long term, and interest rates rise to 5%, your deposit’s return becomes less competitive compared to new deposits offering higher rates.
3. Credit Risk:
Definition: Credit risk is the risk that the financial institution where you deposited your money may face financial difficulties or default. This is generally low for large, reputable banks due to government deposit insurance. Example: If a small bank goes bankrupt and is not covered by insurance, you might lose some or all of your deposit.
4. Liquidity Risk:
Definition: Liquidity risk is the risk of not being able to access your funds when needed without incurring a penalty. Fixed deposits and certain other accounts have restrictions on early withdrawals. Example: If you need cash urgently but have invested in a fixed deposit with a penalty for early withdrawal, you might face financial losses to access your money.