Inflation Risk and Inflation-Protected and Nominal Bonds
Philipp K. Illeditsch
University of Pennsylvania - Finance Department
June 1, 2009
I decompose inflation risk into (i) a component that is correlated with real returns on positive-net-supply securities (stocks, real estate, etc.) and factors that determine investor’s preferences and investment opportunities and (ii) a residual component. In equilibrium, only the first component earns a risk premium. Therefore investors should avoid exposure to the residual component. All nominal bonds, including the nominal money-market account, are equally exposed to the residual component except inflationprotected bonds, which provide a means to hedge it. Every investor should put 100% of his wealth in positive-net-supply securities and inflation-protected bonds and should finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending in the nominal money market account; i.e. investors should hold a zero-investment portfolio of nominal bonds and the nominal money market account.
Number of Pages in PDF File: 30
Keywords: Inflation Risk, Inflation-Proteced Bonds, Inflation-Indexed Bonds, TIPS, Dynamic Asset Allocation, Portfolio Choice
JEL Classification: G11
Date posted: August 25, 2007 ; Last revised: December 7, 2011
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