Question

TIPS or Treasury Inflation Protection Securities incur what kind of risk(s): default risk, interest rate risk, call risk, purchasing power risk, reinvestment risk, or liquidity risk.

Answer 1

a) Default Risk: TIPS or Treasury Inflation Protection Securities are backed by the US government, hence, these are not subjected to the credit risk or default risk.

b) Interest Rate Risk: TIPS inhibits interest rate risk, i.e., the price of the bond will fall with the increase in the interest rates. Hence, TIPS are subjected to the interest rate risk.  

c) Call Risk: TIPS doesn't include any call option, hence, these bonds don't have any call risk.

d) Inflation Risk or Purchasing Power Risk: TIPS have principal and coupon payments linked to inflation. These payments are adjusted as per the inflation as with rising inflation the coupon and principal payments are adjusted upwards. Thus, these bonds do not have inflation risk rather they are hedged against inflation.

e) Reinvestment Risk: TIPS are subjected to the reinvestment risk as it receives inflation-adjusted coupons on a semiannual basis. The investor has the risk of reinvesting the coupons at a lower rate if the market interest rates falls. Thus, TIPS has coupon reinvestment risk.

f) Liquidity Risk: Since, these bonds are issued by the US government, hence, these bonds are traded at high volumes in the market. Thus, if an investor wants to sell this bond, she can easily trade it in the market and doesn't need to sell it at a discount. Thus, these bonds does not include any liquidity risk.