Residual Inflation Risk

Abstract

I decompose inflation risk into (i) a component that is correlated with factors that determine investor’s preferences and investment opportunities and real returns on real assets with risky cash flows (stocks, corporate bonds, real estate, commodities, etc.), and (ii) a residual inflation risk 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 money-market account, have constant nominal cash flows and thus their real returns are equally exposed to residual inflation risk. In contrast, inflation-protected bonds provide a means to avoid cash flow and residual inflation risk. Hence, every investor should put 100% of her wealth in real assets (inflation- protected bonds, stocks, corporate bonds, real estate, commodities, etc.), and finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending cash, that is, investors should hold a zero-investment portfolio of nominal bonds and cash.

Keywords: Inflation Risk, Nominal Bonds, Cash, Money Market Account, Inflation-Protected Bonds, Inflation-Indexed Bonds, TIPS, Dynamic Asset Al- location, Portfolio Choice

JEL Classification: G11