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2022 Dec/19
Relationship between Inflation and Asset Returns: From the Perspective of Hedging against Inflation Risk
Issue Papers 22-25
PDF
- Research Topic Macrofinance
- Page 28
- Summary
- As prices in major economies including Korea have hit record highs in several decades, inflation risk management has grown in importance. In this regard, this article analyzes the relationship between inflation and returns on major assets both in Korea and the US, and presents implications for hedging against the latest inflation risk. The analysis results can be summarized as follows.
First, the relationship between stock or bond prices and inflation could vary depending on whether the current inflation characteristic is counter-cyclical or pro-cyclical. In the counter-cyclical inflation period when rising prices exacerbate the real economy, higher inflation is likely to trigger the simultaneous decline in stock and bond prices. Second, it is hard to predict any change in commodity prices that are deemed a typical inflation hedge, owing to their unstable relation with inflation. Third, the sensitivity to inflation of real estate varies by nation. The correlation between real estate and inflation is positive in the US, while no significant correlation has been identified in Korea. Fourth, as for the Inflation Linked Korea Treasury Bond (KTBi) adopted for hedging against inflation risk, the short- or medium-term KTBi issued in the US and Korea, not a longer-term one, is more useful for inflation risk hedge over the short- and medium-term horizon.
Based on the analysis, this article offers the following implications. First of all, the recent inflation can be characterized by counter-cyclical factors. Therefore, even though stock and bond prices plunge, the response to inflation through diversified investments of stocks and bonds would entail risks. Given the recent trend in commodity prices, commodities are expected to serve as an effective tool to hedge against domestic inflation. However, it should be noted that commodities are useful for inflation hedge only to the extent that they act as determinants of domestic inflation. In addition, considering higher volatility in commodity prices, it is desirable to take into account the correlation between commodities and other assets for risk diversification before making investment decisions. What is also needed is a wide range of maturities for KTBi to hedge against inflation risk over the medium-term horizon. But various considerations except for inflation should be factored in to issue government bonds including KTBi. Hence, financial institutions need to provide support for investors’ inflation risk management through inflation derivatives.