Basis Risk and Inflation Replication

45 Pages Posted: 26 Feb 2014

See all articles by Alexander de Roode

Alexander de Roode

Robeco Asset Management, Quantitative Investment Research; Netspar

Multiple version iconThere are 2 versions of this paper

Date Written: September 8, 2013

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

Suggested Citation

de Roode, Alexander, Basis Risk and Inflation Replication (September 8, 2013). Netspar Discussion Paper No. 09/2013-078, Available at SSRN: https://ssrn.com/abstract=2400537 or http://dx.doi.org/10.2139/ssrn.2400537

Alexander De Roode (Contact Author)

Robeco Asset Management, Quantitative Investment Research ( email )

Rotterdam, 3011 AG
Netherlands

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
60
Abstract Views
662
Rank
305,550
PlumX Metrics