Working Paper: NBER ID: w2322
Authors: Jayendu Patel; Richard Zeckhauser
Abstract: An important risk facing agents in a monetary economy arises from inflation uncertainty: in the U.S. for the 1953-84 period, unexpected quarterly inflation had a standard deviation of 2.1%. The costs of such uncertainty are likely to be even higher for multi-year contracts, since we estimate that a 1% unexpected inflation this year implies an upward revision of 0.43% for expected inflation for the forthcoming year and 1% for the years beyond that. The prospect of hedging inflation risk exposure using conventional financial instruments is bleak, as has been widely documented. We develop a theoretical case for Treasury bill futures as a inflation risk hedge by jointly assuming that (1) the Fisher Hypothesis applies to Treasury bill yields, (2) the Unbiased Expectations Hypothesis (UEH) applies to futures prices, and (3) inflation is an autoregressive process. Our empirical analysis shows that Treasury bill futures can reduce single-period inflation risk by about 30-40%. The expected cost of using such futures is close to zero, since we find that the Unbiased Expectations Hypothesis for Treasury bill futures cannot be rejected. Our results provide new indirect support for the Fisher Hypothesis.
Keywords: Treasury Bill Futures; Inflation Risk; Fisher Hypothesis; Unbiased Expectations Hypothesis
JEL Codes: E31; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unexpected inflation (E31) | revision in expectations of future inflation rates (D84) |
| revision in expectations of future inflation rates (D84) | adjustment in treasury bill prices (E43) |
| unexpected inflation (E31) | cash flows from futures positions (G13) |
| cash flows from futures positions (G13) | hedge against inflation risk (G13) |
| Fisher Hypothesis (G40) | nominal yields driven by inflationary expectations (E31) |
| cash flows from treasury bill futures (G19) | counteract effects of inflation risk (E31) |
| unbiased expectations hypothesis cannot be rejected (D84) | expected cost of using treasury bill futures for hedging close to zero (G12) |