Basis Risk and Inflation Replication

Abstract

We study inflation replication in European markets and find that investors can improve their inflation hedge by acquiring foreign inflation-linked derivatives on the international market. Although European inflation-linked bonds holdings have a substantial impact on the inflation hedging ability, their weight in the hedging portfolio is declining over the investment horizon. We show that UK and US inflation-linked bonds can be attractive as well by exploiting long run dynamics of inflation and currency movements. While under stable conditions the replication ability of these portfolios can be improved, uncertainty about long run dynamics may still influence its hedging performance. We confirm with a Bayesian methodology taking into account the uncertainty associated with long run dynamics that during the Financial crisis local nominal bond holdings increased while foreign inflation-linked bonds decreased. While we observe the flight to local securities for inflation hedging investors, European inflation-linked bond holdings remain steady, showing the importance of these bonds in the replication strategy of the investor.

Keywords: Inflation hedging, basis risk, cointegration, inflation derivatives

JEL Classification: E44, F21, G15