Swapping from Headline to Core Inflation and Commodity Hedging
Insurance Risk - Risk, Oct. 2014
European Business Research Conference Proceedings - Rome IT, 2012
Southwestern Finance Association 2013 Annual Meeting Paper - Albuquerque NM, 2013
AIDEA 2013 Banking & Finance Annual Conference Paper - Lecce IT, 2013
34 Pages Posted: 8 Aug 2012 Last revised: 19 Oct 2014
Date Written: September 16, 2013
Abstract
Headline inflation in most industrialized countries, the US in particular, has been shown to be mean reverting to core inflation in the medium term, whilst at the same time the pass-through of exogenous commodity price shocks from the headline to the core has dramatically gone down as a result of a major macroeconomic paradigm change. It yields lower relative volatility for the latter and creates a drive for investing in commodities as a hedge for the spread between both inflation measures. In this paper, we argue for a risk reduction in ALM strategy in the form of a shift from targeting core rather than headline inflation for long-term hedgers while proposing an overlaying core versus headline swap to hedge the potential asset-liability gap. A market curve for core inflation could be derived from the trading of these derivatives and enable easy mark-to-market valuation of any core-linked securities, thus easing the way for future primary issues. Any supply and demand market disequilibria between sellers of headline inflation and sellers of core inflation could be matched by the intermediation of market makers which could price the derivative based on the cross-hedging potential of commodities.
Keywords: ALM, LDI, Long-term Investment, Inflation Hedging, Core Inflation, Commodities, Inflation Pass-through, Arbitrage Pricing, Synthetic Futures, Inflation Derivative, Monte-Carlo
JEL Classification: C58, C63, E31, F01, G11, G12, G13, G13, G23, G24, Q02
Suggested Citation: Suggested Citation