Working Paper: NBER ID: w18135
Authors: Christopher T. Downing; Francis A. Longstaff; Michael A. Rierson
Abstract: We propose a new approach to constructing inflation tracking portfolios. The key to this approach is the insight that asset returns track expected inflation far better than they track current realized inflation. Thus, we can construct portfolios that track next month's inflation much more closely than they track this month's inflation. We show this staggered hedging approach can eliminate nearly 90 percent of the tracking error of more conventional inflation hedging strategies. We also find that long-short positions in equities play a dominant role in the effective hedging of inflation risk over extended horizons. These results suggest that the goal of protecting portfolios against inflation may be more feasible that is commonly believed.
Keywords: inflation; tracking portfolios; asset returns; hedging
JEL Codes: G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asset returns (G19) | expected inflation (E31) |
| asset returns (G19) | realized inflation (E31) |
| expected inflation (E31) | tracking error (Y10) |
| realized inflation (E31) | tracking error (Y10) |
| staggered hedging strategy (G13) | tracking error (Y10) |
| long-short positions in equities (G12) | inflation risk hedging (E31) |
| traditional approaches (B52) | low contemporaneous correlations (C10) |