Inflation Sensitive Assets

In the wake of the financial crisis a huge
monetary overhang threatens the major

developed economies.
As a result markets have focused attention on

assets that protect the investor from loss of
purchasing power.
Inflation-sensitive assets including
commodities, equities, infrastructure and real
estate investments, and inflation-linked securities
have in fact become a new asset class.
Many institutional investors controlling trillions
of dollars worth of assets are allocating an
increasing weight to the sector as an alternative
and complement to other traditional assets.
This book, for the first time, addresses the

commodities and inflation markets together,
providing a holistic treatment from an inflation
perspective.
Inflation-Sensitive Assets provides the reader with
a deep understanding of the drivers of inflation,
the assets which can be used to hedge it and
how investors can formulate strategies when
managing assets and liabilities in an inflationsensitive environment.
Designed for practitioners, the book includes
important academic contributions, and will be
of interest to portfolio managers, risk managers,
plan sponsors and researchers alike.
This book provides an essential resource for
investors, consultants and service providers
keen to preserve wealth
Mihir Worah, Managing Director,
Head of Real Return Portfolio Management,
PIMCO
Edited by Stefania Perrucci and Brice Benaben
The iron laws of economics have no respect

for modern semantic niceties of quantitative,
credit or monetary easing: these policies all
portend of inflation that must work its way out
of the system.
In Inflation-Sensitive Assets: Instruments and

Strategies, Stefania Perrucci and Brice Benaben
blend insights and experiences from market
participants including investment bankers,
asset and pension fund managers and central
bankers to guide the reader through this
emerging sector.
Inflation Sensitive Assets
The real impacts of inflation and its most

extreme form hyperinflation are known
only too well: they erode value, unbalance
economies and destroy wealth.
Inflation
Sensitive
Assets
Instruments and Strategies
Edited by Stefania Perrucci
and Brice Benaben
PEFC Certified
This book has been
produced entirely from
sustainable papers that
are accredited as PEFC
compliant.
www.pefc.org
Inflation_Sensitive_Assets.indd 1
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Inflation-Sensitive Assets
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Instruments and Strategies
Edited by Stefania Perrucci and Brice Bnaben
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Published by Risk Books, a Division of Incisive Media Investments Ltd

Incisive Media
3234 Broadwick Street
London W1A 2HG
Tel: +44(0) 20 7316 9000
E-mail: books@incisivemedia.com
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www.incisivemedia.com
2012 Incisive Media
ISBN 978-1-906348-62-5
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Publisher: Nick Carver

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Printed and bound in the UK by Berforts Group
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Every effort has been made to ensure the accuracy of the text at the time of publication, this
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While best efforts have been intended for the preparation of this book, neither the publisher,
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from or in reliance upon its information, meanings and interpretations by any parties.
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To the memory of our fathers, Bernard Bnaben and Pietro Perrucci
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Contents
About the Editors
ix
About the Authors
xi
Foreword
Mihir Worah
PIMCO
xix
Acknowledgements
xxi
PART I
INTRODUCTION: MARKETS AND INSTRUMENTS
Stefania A. Perrucci
New Sky Capital
Investable Commodity Indexes and Inflation: A Brief History

Bob Greer
PIMCO
Commodities, Inflation and Growth: Implications for Policy

and Investments
Ric Deverell, Kamal Naqvi
Credit Suisse
1
3
13
25
Inflation and Real Estate Investments

Brad Case; Susan M. Wachter
National Association of Real Estate Investment Trusts
(NAREIT); The Wharton School, University of Pennsylvania
43
Infrastructure Assets and Inflation

Gerald Stack, Dennis Eagar, Kris Webster
Magellan Group
69
Equity Investments and Inflation

Steven Bregman, Murray Stahl
Horizon Kinetics LLC
79
Inflation-Linked Markets
Gang Hu; Stefania Perrucci
Credit Suisse; New Sky Capital
103
Understanding and Trading Inflation Swaps and Options

Brice Bnaben; Herv Cros; Franck Triolaire
New Sky Capital; BNP Paribas; Morgan Stanley
137
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INFLATION-SENSITIVE ASSETS
PART II
9
RESEARCH AND MACRO PERSPECTIVE
The Role of Models in Modern Monetary Policy

Stefania A. Perrucci and David Vavra
New Sky Capital; OGResearch
177
179
10 Term Structure of Interest Rates and Expected Inflation

Olesya V. Grishchenko; Jing-Zhi Huang
Federal Reserve Board; Penn State University
209
11 Monetary Policy, Inflation and Commodity Prices

Frank Browne, David Cronin
Central Bank of Ireland
255
12 Inflation and Asset Prices

John A. Tatom
Indiana State University
277
13 Inflation and Equity Returns

Jeffrey Oxman
University of St Thomas
299
14 Inflation Hedging through Asset and Sector Rotation

Alexander Atti, Shaun Roache
International Monetary Fund
325
PART III
PRACTICAL INSIGHTS FROM MARKET PARTICIPANTS 349
15 Practical Models for Inflation Forecasting

Nic Johnson
PIMCO
351
16 Protecting Insurance Portfolios from Inflation

Ken Griffin and Edward Y. Yao
Conning Asset Management
369
17 Inflation, Pensions and Liability-Driven Investment Solutions

Markus Aakko
PIMCO
389
18 Ultra-High-Net-Worth Investors and the Real Asset Value Chain 423

Ian Barnard
Capital Generation Partners
19 Inflation Markets: A Portfolio Managers Perspective
New Sky Capital
435
20 Inflation Indexation and Products in Emerging Markets

Brice Bnaben, Stefania A. Perrucci
New Sky Capital
479
Index
507
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About the Editors

Stefania Perrucci is the founder and CEO of New Sky Capital, an
independent investment and advisory firm with offices in Philadelphia and London. She has 15 years of investment experience, spanning both traditional and alternative asset classes. Before founding
New Sky, she was a portfolio manager at Morgan Stanley, where she
consistently ranked among the top-quartile performers. Her flagship
fund was the recipient of a Lipper Funds Award in 2008 (based on top
three-year trailing performance). Before joining Morgan Stanley, she
was a risk management specialist at the IFC, part of the World Bank
Group. Stefania has established herself as a recognised thoughtleader and independent-minded investor. In 2006, she was one of the
few buy-side voices advocating a long insurance position to protect
against the effects of an imminent collapse in house prices. She is
the author of several proprietary models, with one patent awarded
and another pending. She has published cutting-edge research on
several market topics, and speaks regularly at industry conferences
around the globe. She is the editor and author of Mortgage and Real
Estate Finance. Stefania received her PhD in theoretical physics from
the University of Virginia, and a Laurea Summa Cum Laude from
the University of Modena, Italy. She has held academic positions
at universities in both the US and Europe, receiving more than a
dozen awards, in recognition of outstanding academic and teaching
achievement.
Brice Bnaben is a managing director and head of inflation research
at New Sky Capital. He has 15 years of investment experience. Previously, he held positions as managing director and global head of
property derivatives and inflation trading at Deutsche Bank, deputy
head of inflation at Citibank, head of inflation structuring at ABN
AMRO, head of fixed income and portfolio strategy at Credit Agricole Indosuez and portfolio manger/trader at the IFC (World Bank
Group). Brice is the editor and author of Inflation-Linked Products,
co-editor and author of Inflation Risks and Products, and co-authored
Real Estate Indexes and Property Derivative Markets in Mortgage
and Real Estate Finance. He is a graduate of the University of Oxford,
where he studied applied mathematics.
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About the Authors

Markus Aakko is an executive vice president at the Pacific Investment Management Company (PIMCO), working with pension plans
and institutional clients. Prior to joining PIMCO in 2010, he was a
managing director and portfolio manager in global portfolio solutions within Goldman Sachs Asset Management (GSAM). His prior
experience with GSAM includes roles as head of risk management
and head of fixed income for manager selection. Before joining
GSAM, Markus worked with the International Finance Corporation
at the World Bank.
Alexander P. Atti is a senior financial officer with the International
Monetary Fund (IMF). He works on the design and implementation
of investment strategies for the IMFs reserves and for assets of trust
funds that support concessional lending. Prior to joining the IMF in
2005, he worked for Banque de France as a fixed-income portfolio
manager for eight years. He graduated from the Institut dtudes
Politiques de Paris in 1993 with a major in economics.
Ian Barnard is a founding partner and chief investment officer of
Capital Generation Partners LLP. Ian is a regular speaker at conferences and has contributed articles to the general and more specialised press. He has advised on structured finance, and mergers
and acquisitions at Smith Barney, completed an MSc in management
at London Business School and, from Geneva, advised a familyowned investment group on direct and portfolio investments. Ian
also served in HM Diplomatic Service, both in London and abroad,
concentrating on the Middle East, as well as serving briefly in the
British Army.
Steven Bregman is the portfolio manager of Horizons core value
strategy and was a co-founder of the firm. He serves on the investment committee and the board and is a senior member of Horizon Kinetics research team, with oversight responsibilities for all
research reports produced by the firm. Previously, he was a senior
investment officer in the private bank at the Bankers Trust Company
(198594), where he was a member of the institutional/individual
group responsible for the banks larger individual relationships and
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for setting equity investment guidelines for the private bank. Steven
also served as a member of the special situations equity strategy
group, and in a variety of new product development projects. He
has a BA from Hunter College and gained a CFA in 1989.
Frank Browne is senior advisor to the Governor, Central Bank of Ireland. He previously worked as senior economist at the OECD (1988
92), as deputy head of Stage 3 (EMU) Division at the European Monetary Institute (19948) and as advisor to the research directorate at
the European Central Bank (19982000). He has been a member of
the ECB Monetary Policy Committee and the ECB Bank Supervision
Committee. Franks research has been published in European Economic Review, Review of Economics and Statistics and The Manchester
School.
Brad Case is senior vice president of the research and industry information group for the National Association of Real Estate Investment
Trusts (NAREIT). His research has been published in Review of Economics and Statistics, Real Estate Economics, the Journal of Real Estate
Finance and Economics, Journal of Portfolio Management and other academic and industry publications. He is the co-inventor of PureProperty indexes of commercial property values as well as backward
forward trading contracts. Brad earned his BA at Williams College,
his MPP at the University of California at Berkeley, and his PhD in
economics at Yale University.
David Cronin is senior economist at the Central Bank of Ireland.
He has represented the Bank at various European System of Central
Banks committees and at other forums. He has published articles in
journals such as Journal of Economics and Business, Empirica and The
Cato Journal, among others.
Ric Deverell is a managing director and head of the commodities research team at Credit Suisse. He previously spent 10 years
at the Reserve Bank of Australia, holding several senior positions
including deputy head of economic analysis and chief manager of
international markets and relations. During the 1990s, Ric worked in
the Department of the Prime Minister and the Australian Treasury,
where he was head of the Asian section during the Asia crisis. His
research interests include analysis of the global business cycle, the
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ABOUT THE AUTHORS
emergence of the Asian economies and developments in commodity markets. Ric is a graduate in economics from the University of
Tasmania.
Dennis Eagar manages global listed infrastructure investment portfolios for Magellan Asset Management on behalf of retail and wholesale investors. The team is regarded as expert in the investment
analysis and valuation of infrastructure assets and has more than
50 years collective experience in infrastructure investment. The
team has advised on investment in airports, ports, toll roads, communications infrastructure, pipelines, electricity distribution and
transmission, and water and waste water treatment and distribution.
Robert J. (Bob) Greer is an executive vice president and manager
of real return products at the Pacific Investment Management Company (PIMCO). He managed commodity index business for Daiwa
Securities, Chase Manhattan Bank and JP Morgan. Bob developed
one of the two common methods of explaining sources of commodity
index returns and has spoken on this asset class in college lectures,
on national television, and at industry conferences and trade meetings. He has published in The Journal of Portfolio Management and The
Journal of Derivatives, among others. He has consulted on commodities for the CIA, the Bank of England and the New York Fed. Bob is
the author of The Handbook of Inflation Hedging Investments. He has
a Bachelors degree in mathematics and economics from Southern
Methodist University and an MBA from Stanford Graduate School
of Business.
Ken Griffin is a managing director at Conning, where he heads
the life and health advisory team that is responsible for providing
assetliability and integrated risk management advisory services to
life and health insurance company clients. He also serves as a lead
consultant for various capital management and investment-related
projects involving global life and property and casualty insurance
companies. Prior to joining Conning in 2001, Ken held various positions within Swiss Re Investors ALM unit. He has been involved in
product development, insurance securitisations, ALM and investment portfolio management for insurance companies since 1997. He
is a graduate of the University of North Carolina at Chapel Hill with
a BA in Economics.
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Olesya V. Grishchenko is an economist in the monetary affairs division of the Board of Governors of the Federal Reserve System, conducting research and policy work related to the term structure of
inflation expectations, inflation uncertainty, deflation probabilities
and on the term structure models of real interest rates. She has a
PhD in finance from the Stern School of Business of New York University, and previously worked as an assistant professor of finance
in the Smeal College of Business, Penn State University. Olesya
is a visiting assistant professor of finance at the New Economic
School of Moscow, with research interests in empirical asset pricing,
consumption-based modelling and computational methods. She has
published in the Journal of Economics and Business and Journal of Business and Economic Statistics and is a member of the American Finance
Association and the European Finance Association.
Gang Hu is a managing director of Credit Suisse in the fixed income
division, based in London. Within the fixed-income division he is
the global head of inflation, responsible for the US, UK, EU and
developed Asia in linear and non-linear inflation business. He joined
Credit Suisse in July 2011 from PIMCO, where he was an executive vice president in the real return team, co-managing the largest
inflation fund group in the world. Prior to that, Gang worked at
Deutsche Bank, running the US inflation business. He has 11 years
experience in the banking industry and holds a BA in applied mathematics from Tsinghua University and a PhD in applied mathematics
from California Institute of Technology.
Jing-Zhi (Jay) Huang is a McKinley Professor of business and associate professor of finance at the Smeal College of Business, Penn
State University. His research interests include derivatives markets, credit risk, fixed-income markets, mutual funds and hedge
funds. His papers have been published in The Journal of Finance,
Economic Theory, Journal of Derivatives, Journal of Fixed Income, Journal
of Real Estate Finance and Economics and Review of Derivatives Research,
among others. He won the Best Paper Awards at the Financial Management Association and the Eastern Finance Association Meetings,
and NYUs Stern School Club 6 Teaching Award. He received his
PhD in physics from Auburn University, and his PhD in finance
from New York University.
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ABOUT THE AUTHORS
Nicholas Johnson is an executive vice president and portfolio manager at the Pacific Investment Management Company (PIMCO),
where he focuses on commodities and inflation. He previously
managed the portfolio analysts group. Prior to joining PIMCO in
2004, he worked at NASAs Jet Propulsion Laboratory, developing
Mars missions and new methods of autonomous navigation. He has
eight years of investment experience and holds a masters degree
in financial mathematics from the University of Chicago and an
undergraduate degree from California Polytechnic State University.
Kamal Naqvi is a managing director of Credit Suisse in the investment banking division, based in London, where he is the head of
institutional commodity sales. He has over 15 years experience in
the resources industry. He joined Credit Suisse in July 2007 after four
years at Barclays Capital, where he was responsible for coverage of
hedge funds and institutional clients across commodity products,
after previously being a director in the commodity research team.
Prior to that, he was a commodities analyst with Macquarie Bank
in London, after having worked for CRU International in London
as part of both the lead/zinc and precious metals teams. Kamal
began his career as a project manager/economist for the mining
and mineral processing division of the Tasmanian State Government
Department of Development and Resources. He holds degrees (with
honours) in law and in economics from the University of Tasmania.
Jeffrey Oxman is an assistant professor of finance in the Opus College of Business at the University of St Thomas in Minneapolis,
MN, USA. His research has been published in the Review of Derivatives Research and Economics Letters. His research interests include
inflation, value investing and corporate finance. He holds a PhD in
finance from Syracuse University in New York.
Shaun K. Roache is an economist in the Western Hemisphere department of the IMF. He has worked in various countries, including
Brazil and China, contributing to the IMFs analysis of global commodity markets, and worked as part of the team managing the IMFs
investments. Previously, Shaun worked for 10 years as a global financial market strategist, for companies including ING Barings and
Citigroup. He holds a PhD in economics from Birkbeck College,
University of London and is a CFA charterholder.
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Gerald Stack manages global listed infrastructure investment portfolios for Magellan Asset Management on behalf of retail and wholesale investors. The team is regarded as expert in the investment
John A. Tatom is director of research at Networks Financial Institute and associate professor of finance at Indiana State University.
From 2000 to 2005, he was an adjunct professor in the economics
department at DePaul University in Chicago, and during 20034 he
was also a Senior Fellow at the Tax Foundation in Washington, DC.
From 1995 to 2000, John was with UBS in Zurich in various positions,
including executive director and head of country research and limit
control, and chief economist for emerging market and developing
countries. From 1976 until 1995, he was a research official and policy
adviser at the Federal Reserve Bank of St Louis. He has taught at
several colleges and universities and holds a PhD from Texas A&M
University.
Franck Triolaire is an executive director at Morgan Stanley. He has
covered global inflation products since 1999 and is the head of inflation trading for Europe and Asia. He started on the buy-side in
Sinopia, trading inflation products and derivatives. Franck joined
BNP Paribas in 2004 as an inflation trader, took over the euro flow
franchise in 2005 and put BNP Paribas on the top of the rankings
with issuers and customers. He is highly connected in the inflation
space and has managed several government inflation linked bond
issues for France, Germany and Italy. He became co-head of inflation
trading for Europe and Asia in 2008 and head in 2010, promoting
inflation products on cash, derivatives, volatility and structures.
David Vavra runs a consultancy specialising in macroeconomic
modelling and forecasting, helping the pricing of financial instruments in currencies with shallow local markets. He also works as
consultant for the IMF, doing research and applied work on monetary and other issues in a number of countries. David assisted
the National Bank of Serbia in implementing its inflation-targeting
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ABOUT THE AUTHORS
regime and helped to develop forecast-based decision-making systems in the central banks of Colombia, the Czech Republic, Croatia,
Turkey and Peru. He was associated with the Czech National Bank,
leading the macroeconomic modelling and forecasting division and
advising the Governor.
Susan M. Wachter is the Richard B. Worley Professor of financial
management, professor of real estate and Finance at The Wharton
School, University of Pennsylvania. She is also the co-director of the
Penn Institute for Urban Research. From 1998 to 2001 she served
as Assistant Secretary for Policy Development and Research at the
US Department of Housing and Urban Development. She was the
editor of Real Estate Economics from 1997 to 1999 and serves on the
editorial boards for several real estate journals. She is the author of
more than 100 scholarly publications.
Kris Webster manages global listed infrastructure investment portfolios for Magellan Asset Management on behalf of retail and wholesale investors. The team is regarded as expert in the investment
Edward Y. Yao is a vice president at Conning, where he is responsible
for providing advisory services to property and casualty insurance
company clients with respect to strategic asset allocation and integrated assetliability risk management. Prior to joining Conning in
2008, he was a pricing actuary with Travelers Insurance Co. Edward
has provided actuarial consulting services to a variety of clients since
2000. He holds a degree in economics from Qingdao University,
China, and masters degrees in economics and computer science
from Vanderbilt University.
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Foreword
Inflation ranks among the most insidious and destructive of economic forces.
At the extreme, hyperinflation as seen in Germany during the
Weimar Republic in the 1920s, when prices doubled every few days,
or Hungary in 1946, when prices doubled every 15 hours can
destroy the value of paper money and social cohesion. Even moderate inflation can pick the pockets of savers, erode the competitiveness of industries and nations and wreak havoc with investment
portfolios designed to preserve purchasing power.
Since Paul Volcker broke the back of the Great Inflation in the early
1980s, the US has enjoyed three decades of uninterrupted, low inflation. In fact, in the aftermath of the financial crisis of 2008, deflation,
not inflation, has seemed the larger risk.
Nonetheless, the outlook for inflation has grown more uncertain,
the investment challenges and opportunities more immense. A mix
of unconventional monetary policy and massive fiscal stimulus has
saddled the US with an unsustainable debt load, leaving few solutions: faster economic growth, higher taxes, reduced spending or
inflation. Among these, inflation is the easiest, at least in political
terms, and the most likely: no act of Congress is required.
Moreover, if the Federal Reserve wants to engineer inflation to
lower the nations debt-to-GDP ratio, as it did in the years after
World War II, it will have plenty of help from secular trends. In
developing nations, which over the past 20 years have exerted disinflationary pressure through exports of low-cost goods and services,
nearly 2 billion people are likely to join the middle class over the next
two decades moving from huts to concrete apartments, mopeds to
sedans and putting upward pressure on prices for food, crude
oil, copper and other essential commodities. A slowdown in productivity improvement in emerging economies also could translate
into higher production costs and, ultimately, higher export prices.
Although aggressive inflation of the sort seen in the 1970s appears
unlikely, investors should remain vigilant: history shows that price
spikes can come abruptly, with little warning (think of the Arab oil
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embargoes of the 1970s). Indeed, its structural roots are so deep that
inflation can make us feel as helpless as individuals against the tide.
Yet it need not be so. Armed with an understanding of the factors
that drive inflation, and the way inflation-sensitive asset classes perform and correlate with each other, it is possible to prepare for and
manage a variety of inflationary scenarios. Inflation does not always
need to be pernicious; it can also be propitious. What is needed is a
dynamic portfolio of inflation-sensitive assets.
This book provides an essential resource for investors, consultants
and service providers keen to preserve wealth. Essays from a wide
range of experts and thought leaders, including some of my colleagues at PIMCO, explore the risk factors that drive inflation and
the tools and vehicles investors can use to realise attractive potential
returns in a variety of inflation scenarios.
Part I examines the building blocks, and related derivatives, of
what should be viewed as a new asset class of inflation-sensitive
assets, including investable commodity indexes, real estate, infrastructure and inflation-linked bonds. Part II moves to a more theoretical level, exploring: models used to forecast inflation and term
structures of interest rates; the interaction of monetary policy, inflation and commodity prices; theories of inflation and its impact on
equities, fixed income and other asset classes; and ways to hedge
inflation through asset and sector rotation. Part III provides practical guidance to investors, with chapters on: strategies for liabilityand real-asset management for insurance, pension and ultra-high
net-worth portfolios; trading tactics; and inflation-linked markets in
emerging countries.
I hope these insights give you new ways to think about inflation
and practical tools for preserving your purchasing power.
Mihir Worah
Managing Director,
Head of Real Return Portfolio Management,
PIMCO
May 2012
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Acknowledgements
Many people had an important role in the successful completion of
this volume. First in line, our excellent contributing authors: thanks
for your dedication, your hard work and for making this project the
great book it has become.
Over the past year, the team at Risk Books has provided much
needed guidance, enthusiasm and support. It has been a pleasure to
work with them.
Last but not least, to the team at New Sky Capital, and to our
families and friends, thanks for your patience and support during
the creation of this volume.
Brice Bnaben
Philadelphia, June 2012
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Part I
Introduction:
Markets and Instruments
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New Sky Capital
In this chapter, we discuss how inflation should be analysed and

managed as a key portfolio risk. We also discuss the birth of a
new asset class, composed of inflation sensitive assets, that has now
gained explicit stand-alone classification and allocation by several
large institutional investors, including pension funds and insurance
companies.
The first section introduces the concept of inflation risk. We then
analyse some macro issues affecting inflation and asset prices. This
provides a natural introduction to why inflation-sensitive assets,
and not just inflation-linked products, should be viewed as a separate asset class and should receive consideration in any diversified
investment strategy.
INFLATION RISK AND EVALUATING INVESTMENTS IN REAL
SPACE
Although most commonly used investment metrics measure nominal risk and returns, a more rational approach calls for evaluating investments on a real, ie, inflation-adjusted, basis, as investors
should be concerned about preserving or, even better, increasing
their purchasing power.
This is not an academic distinction, but a very consequential one.
In fact, historic episodes, for example, stagflation in the 1970s and
the lost decade in Japan, show the damaging impact that both
high inflation and deflation can have on investment portfolios and
asset prices. Despite this, inflation remains an often mismanaged,
if not completely disregarded, portfolio risk. Indeed, this is particularly worrisome at this junction, after almost 30 years of secular
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Figure 1.1 Annual inflation rates

30
US
Germany
Great Britain
Japan
25
20
15
Great Moderation
%
10
5
2010
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
0
5
Source: New Sky Capital.
bull bond market, and the generally successful anchoring of inflation within a small range. After the Great Moderation in the 1980s
onwards, and an orderly downward convergence of global inflation
rates (Figure 1.1), we are seeing a divergence between developed versus emerging markets, with both deflationary and inflationary forces
at play. As a result of this dichotomy, the necessity to understand and
manage inflation risk is greater than ever.
Policymakers, in particular, will have to design and implement
the right exit strategies, in order to moderate easy monetary stances
in developed countries without choking growth or to control overheating emerging economies without triggering a collapse in asset
prices. It is a delicate balance, as even small shocks to money supply or real growth can have a large effect on medium-term inflation, while a loss of confidence in central banks and policymakers
can undermine the long-term anchoring of inflation expectations.
Because of these inherent sensitivities, there is little room for error.
Of course, inflation represents not just a risk but also an investment opportunity. We shall expand on this in greater detail in
Chapter 19.
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Figure 1.2 US CPI-U weights of major components (as of December

2011)
Other services
20%
Food
15%
Core goods
24%
Shelter
31%
Energy
9%
Values have been rounded. Source: Bureau of Labor Statistics, New Sky Capital.
INFLATION: BASIC CONCEPTS

For the purpose of this chapter, we shall happily gloss over the different definitions of inflation and the inherent biases of the methodologies used to measure it, as well as the never-ending discussions
among different schools of economics on the topic, and simply define
inflation as a rise in the cost of living.
Several indexes and various methodologies are used to measure
inflation, generally relying on a defined basket of goods and services whose price is monitored over time. These indexes are typically published monthly, with a delay, and often seasonally adjusted.
For example, the US CPI-U (Consumer Price Index for All Urban
Consumers) is the key measure of US headline inflation, published
monthly by the Bureau of Labor Statistics,1 usually around the middle of the following month. See Figure 1.2 for an illustration of the
weights of the major components in the US CPI-U.
Intuitively, price inflation arises when too much money is chasing
too few goods. Money is defined as the legally accepted medium
of exchange for goods and services. This is more than currency,
and might include on-demand deposits (which can be readily converted into cash, in essence what is typically referred to as the M1
aggregate) or extend to saving and money market accounts, ie, M2.2
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Figure 1.3 US money and banking system

Good
Goods
producer
Deposit into bank

91
$$$
$$$ $$$
Bank credit
$$$ $$$
$$$
$$$
$$$
$$$
Bank
US government
pays for goods
US Govt
The Federal Reserve

credits the US
Treasury money
in exchange
for debt
$$$
Treasury
bond
Federal
Reserve
Bank
loans
91
This relation is obviously dynamic, as both money and goods

are created/produced and destroyed/consumed over time. Therefore, inflation cannot be understood without an understanding of the
mechanics of the real economy, the banking system and how monetary policy works. Specifically, in the US, money is synonymous
with debt (Perrucci 2011a): the government finances its expenditures
through the issuance of Treasury securities (bought by investors
and/or the Federal Reserve), while the private sector gets financing
through the extension of bank credit (fractional system); the mechanism is illustrated in Figure 1.3. Consequently, both fiscal policy
(driven by the US Government) and monetary policy (driven by
the Federal Reserve) are key determinants of money as well as the
economy.
A MACRO APPROACH: THE DIFFERENT CAUSES OF
INFLATION
Several macroeconomic and policy factors influence the path of inflation. As a consequence, inflation risk cannot be managed in isolation.
A macro approach is crucial, and so is an understanding of the interactions with other traditional factors affecting the value of both real
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Inflation
Figure 1.4 Expectation-augmented Phillips curve
Unemployment
and financial assets (real and nominal rates, liquidity spreads, credit
spreads and equities, commodities, real estate, volatility, foreign
exchange rates, etc).
One of the most well-known macro models of inflation is the
Phillips curve (Phillips 1958). This describes the inverse relationship
between inflation and unemployment observed in many countries,
for example, in the UK and the US. Among other things, this relation poses a difficult trade-off for policymakers, who need to balance
price stability with full employment. However, models based on the
Phillips curve were questioned in the 1970s, when many countries,
including the US, experienced stagflation, ie, high inflation in the
midst of stagnant growth. If, at times, inflation and employment do
not move along the Phillips curve, the obvious solution is to move
the curve itself.
Accordingly, new models came about where the relation between
inflation and unemployment (or alternative measures of real economic activity, eg, capacity utilisation) became a dynamical feature.
In these models, inflation and unemployment could move along
the usual Phillips/demand-pull curve, while the curve itself could
be subjected to up or down moves in response to cost shocks (eg,
commodities price spikes) or change in inflation expectations (as
observable in inflation surveys or the inflation linked market). Figure 1.4 shows a schematic representation of expectation-augmented
Phillips curve models.
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In expectation-augmented Phillips curve models, inflation can

arise as a result of
supply/demand imbalance (demand-pull or cost-push infla-
tion),
a change in inflation expectations.
In turn, supply/demand of goods and money, as well as changes in

inflation expectations, can arise for a variety of reasons, including
change in money supply, fiscal/monetary policies (and their credibility), exogenous shocks (such as commodity and currency spikes),
changes in competitive landscape and global trade effects.
The underlying cause of inflation is of critical importance for
investment decisions, as, although the end result might be the same
in terms of inflation print, the effect on different asset classes (or subsectors within the same asset class) will be quite different. For example, without entering into the details of the relationship between
equity returns and inflation (a topic explored in later chapters),
demand-pull inflation is typically more equity friendly than costpush inflation, although both shocks might have a similar effect on
commodity prices.
INFLATION AND ASSET RETURNS
In the previous section, we explained that not all inflation is created equal, as the underlying causes can be different, and thus affect
different asset classes in distinct (or even opposite) ways.
Unfortunately, studying the effect of inflation on different investments is not as straightforward as it might seem to be. Traditional
historical studies often suffer from several biases. Thus, care must
be taken to interpret (or extrapolate) their results, as the latter might
hide rather than reveal the true underlying dynamics at play. We
give some specific examples below.
In historical analysis, broad sector indexes are most often
used, and general conclusions are drawn. However, equity

or commodity indexes might behave quite differently from
specific subsectors (cyclical versus non-cyclical equities, dividend stocks, commodity-linked stocks, energy versus food or
industrial commodities).
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Furthermore, market prices embed expectations about future
macroeconomic conditions; thus, asset returns are often not

coincident but might anticipate future realisation (so lags
should be considered in the analysis). For example, equity and
industrial commodity prices embed forecasts of future growth
(among other things), and thus tend to anticipate (correctly or
not) real GDP. Ditto for the slope of the yield curve, with a flat/
inverted curve being a recession signal.
In addition, traditional historical studies often do not dis-
criminate among the different underlying causes of inflation.

Thus, historical data might not be relevant going forward; past
episodes of high (low) inflation might not provide a meaningful comparison with the next inflation (deflation) shock,
with different underlying causes or a different mix of economic
conditions.
In the authors experience, it is crucial to go beyond historical studies of asset returns or average correlations, and to understand the
macro-drivers behind those returns and correlations and how these
might play at different stages of the business cycle. The ability to do
so has a huge impact on the riskreturn trade-off of any successful
real return strategy. This topic will expanded upon in Chapter 19.
A NEW ASSET CLASS: INFLATION-SENSITIVE ASSETS
When considering inflation as a risk to be managed, the first asset
class that comes to mind is that comprised of inflation-linked bonds
and derivatives. Indeed, these instruments are most directly and
transparently linked to inflation (in a formulaic way), and they have
had tremendous growth in sophistication and liquidity since their
introduction (Chapters 7 and 8). Obviously, inflation-linked instruments provide attractive investment opportunities (Perrucci 2010)
as well as diversification benefits to traditional portfolio allocation.
However, inflation-linked products are not the only inflationsensitive instruments available to the real return manager. Indeed,
especially for actively managed strategies, it is important to determine whether a particular view is most efficiently implemented
using inflation-linked products directly, or other inflation sensitive assets (such as commodities, equities, real estate assets, infrastructure investments, etc). Coincidentally, this is consistent a global
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trend, with several pension funds, insurance funds, and even wealth
funds, changing their traditional asset allocation to include a new
inflation-sensitive sector, along with the more traditional equity,
fixed income and credit sectors. The newly defined asset class has
steadily gained weight in portfolio allocations from several institutional investors. The shift is of monumental importance in the asset
management industry, as these institutions control trillions of US
dollars of capital in the space.
There are tangible benefits in defining inflation-sensitive assets
to include other instruments in addition to inflation-linked cash and
derivative securities.
Diversification: these instruments have distinct return distri-
bution characteristics and macroeconomic drivers, thus providing diversification in real return space. For example, several analytical studies show how portfolios should allocate
to inflation-linked securities at low/moderate return targets,
while other inflation-sensitive assets such as commodities or
equities gain a higher weight as the riskreturn target of the
portfolio is increased along the efficient frontier. Notably, studies made in real (rather than nominal) return space reach even
stronger conclusions in regard to this point (Perrucci 2011b).
Pricing: often a similar macro/inflation view is priced across
different asset classes, but to a different degree (because of

each assets distributional characteristics, timing or other factors). This might at times provide an alternative to leverage
when trying to achieve target returns. For example, deflation
was priced in US Treasury Inflation Protected Securities (TIPS)
inflation break-evens when headline CPI plunged in autumn
2008; clearly oil futures provided a directionally similar trade
with no need for leverage.
Different risk premiums in different securities: for example,
there is an inflation risk premium to buying insurance directly

in inflation-linked instruments (whether in the cash or derivative markets). This is a consequence of the fact that, for a US
investor, TIPS might be considered the closest thing to a riskfree asset class (if held to maturity, and putting lags and basket
definition aside). Note, however, that bond break-even inflation levels contain both a liquidity and an inflation-insurance
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risk premium, with the latter often dominating the former

(with several important exceptions, for example, the autumn
2008/spring 2009 liquidity crisis/deflation scare). Another
investor might be considering hedging a possible negative real
growth/deflation shock to the economy. While buying inflation floors might be one implementation, the investor might
notice that inflation implied volatility is at high levels relative
to realised, the inflation market usually being short volatility
and might then consider buying out-of-the-money equity puts
(or a short inflation floor/long equity put relative value trade).
Niche opportunities: at times attractive opportunities can occa-
sionally be found and/or structured in niche markets where

profit margins are still high. The author has seen several
such opportunities, one example being in infrastructure and
inflation-linked investments.
In summary, inflation-sensitive assets provide diversification benefits beyond linkers, and the ability to implement hedging or relative
value trades in the sector(s) where conditions are most favourable
(because of valuations, risk, leverage, etc).
CONCLUSIONS
In this chapter, we have discussed inflation as a key portfolio risk.
After an analysis of the underlying causes of inflation, we argued
for the tangible benefits of defining inflation-sensitive assets as a
broad investment class, which should include commodities, equities, real estate and infrastructure assets in addition to inflationlinked cash and derivative securities. This is consistent with a global
trend, with several pension funds, insurance funds, and even wealth
funds, changing their traditional asset allocation to include the
newly defined inflation-sensitive sector, along with the more traditional equity, fixed income and credit sectors. As such institutions
together control trillions of US dollars of capital in the space, this
shift is of monumental importance to any portfolio manager as well
as to the whole asset management industry.
1
See http://www.bls.gov/.
See http://www.federalreserve.org/ for a more detailed explanation of monetary aggregates.
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REFERENCES
Perrucci, S., 2010, Inflation-Sensitive Assets: Portfolio Benefits and Opportunities, URL:
http://www.newskycapital.com.
Perrucci, S., 2011a, Inflation, Money and Debt, URL: http://www.newskycapital.com.
Perrucci, S., 2011b, Efficient Frontier and Optimal Portfolios in Real vs Nominal Space,
URL: http://www.newskycapital.com.
Phillips, A. W., 1958, The Relationship between Unemployment and the Rate of Change
of Money Wages in the United Kingdom 18611957, Economica 25(100), pp. 28399.
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Investable Commodity Indexes and

Inflation: A Brief History
Bob Greer
PIMCO
In this chapter, we present a brief history of investable commodity indexes, and discuss the link between inflation and commodity
prices.
The first section covers the 1970s, and the effect of energy and food
price spikes on inflation and traditional asset classes. Commodity
futures are discussed next, as well as the authors work in building
the first investable commodity index. A brief recap of the evolution
in commodity indexing and investment vehicles until the present
day1 follows. We then conclude with a discussion of commodities
as an inflation hedge.
COMMODITIES SHOCKS AND INFLATION

Awareness of the relationship between commodities and inflation
was heightened during the 1970s. Oil price shocks, at the height of
the OAPEC embargo in 19734,2 and during the Iran Revolution
in 1979, drove prices of petroleum and the cost of other products
up. Several crop failures and supply shortages in some grains (such
as the one originating from the Russian wheat deal of 1972 (Luttrell 1973), where about 30% of US annual wheat production was
sold to Russia, with taxpayer-paid government subsidies going to
US grain exporters) drove up agricultural prices as well. President
Nixons attempts at controlling inflation, through price and wage
restrictions, were unsuccessful, and only distorted markets further.
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Despite these events highlighting the importance of the link between commodities and inflation, investors did not have an effective way to get exposure to commodity prices in order to hedge
inflation. Some tried to purchase natural resource stocks, but those
investments carried other risks as well, in particular a significant
correlation to the overall equity market, with movements in the latter often overshadowing changes in commodity prices themselves.
Other institutional investors, who had very long investment horizons, tried to purchase real commodity-producing assets, such as
farmland. But, besides being illiquid, these investments were also
exposed to other non-essential risks, on both the operational and
finance sides (weather, government regulations, political risk, etc).
All of this set the perfect stage for the developments that followed.
COMMODITY PRICE INDEXES AND FUTURES
There has been interest in commodity prices, and indexes of those
prices, for a very long time. Until the late 1970s, the available indexes
typically referred to prices of physical commodities. Some of these
early indexes were published by Reuters, the Financial Times and
The Economist, among others. They comprised a broad range of commodities, including some for which there were futures markets, as
well as others that had no futures equivalent. There was also a variety of other indexes of cash prices for specific industries within the
commodity asset class, including livestock, energy products and
mining products. Both Dow Jones and the Commodity Research
Bureau published indexes which used the current or spot month
price from commodity futures markets as a surrogate for cash markets, partly because this information was readily available. But, like
those other early price indexes, those based on futures prices were
also not investable, because they could not be replicated. That is,
they simply reported the spot month price as a surrogate for cash
prices, without accounting for the fact that an investor would have
to roll their exposure from a nearby contract to a distant contract
before expiry, which can affect returns, sometimes dramatically. That
is because those early index calculators only wanted a measure of the
level of cash prices; the concept of actually investing in commodity
futures had not yet been considered.
During the inflation and related shortages of several commodities in the 1970s, the interest in commodities as investments began
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INVESTABLE COMMODITY INDEXES AND INFLATION: A BRIEF HISTORY
to take root. Although the impact of higher commodity prices on

inflation was well understood, the possibility of hedging against
this, via a systematic investment in a basket of commodities, was not
appreciated. No investors were getting exposure to anything like a
broad-based index of commodity prices. This began to change when
commodity futures gained acceptance in the investment community,
as a surrogate for ownership of physical commodities.
Interestingly enough, the mid 1970s were also a time when the
first stock index fund3 was offered (of course, there had been stock
price indexes for many, many years before). This development in
the equity market inspired the author to find an analogous way
for investors to gain exposure to commodities as well. What might
seem a natural idea today was actually quite original in the 1970s, as
commodities were viewed as a very high-risk speculative instrument, and thus quite different from investing in the shares of a
company. In reality, the price of an individual commodity, such as
wheat, for example, was typically no more volatile than the price
of a single stock, such as IBM. Furthermore, while companies can
go bankrupt, cattle cannot. Even in the 1956 debacle in the onion
futures market4 , the price of the contract did not go to zero (it went
to 10 US cents, which was about the cost of the bags in which the
onions were stored).
The reasons why commodities were thought of as being so risky
are twofold. First, since physical ownership of the underlying commodity is typically not practical, most investors traded in the futures
markets, and often used a large amount of leverage. This leverage
was possible because the market participant did not actually buy, or
sell, a physical commodity on a cash basis. Instead, they just made a
commitment to buy, or sell, a commodity in the future. As long as the
participant closed their position before they were contractually obligated to take (or give) delivery of the physical commodity, they only
had to deposit sufficient margin to ensure that they could perform
on that future commitment. This margin would of course change in
line with the price of the futures contract. This allowed the market
participant to control a large notional amount, with only a small capital commitment. Hence, small adverse movements in the price of
commodities could (and sometimes did) entirely wipe out the capital
of this leveraged investor. The margin deposit might be thought of
as being similar to the earnest money deposit that is typically made
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by a buyer of a house, when that house is put under contract. The

full amount of the purchase price is required only at time of contract
settlement. This leads to the second reason that commodity investment was misunderstood. Many investors did not understand the
very nature of a futures contract. They equated having a long position in a commodity futures market with outright ownership of the
commodity itself.
Of course, it is possible to fully collateralise a long commodity
futures contract, and thus take leverage out of a commodity investment. For example, if a live cattle contract (40,000 lb) were trading
at 50 US cents per pound, the notional value of the contract would
be US$20,000. Instead of making a minimum margin deposit of, say,
US$1000, the investor could allocate a full US$20,000 of their portfolio to support a single long contract in cattle. The investor thus
would have the capital to actually purchase the cattle if they chose
to do so and, no matter how low the price of cattle might fall, the
investor would have money to meet any margin call. In this strategy,
the investors total return is the return on collateral, plus or minus
the change in the price of the cattle futures contract. Note, however,
that full collateralisation can only take place with long futures positions, as we cannot determine how much collateral is required to
support a short position, since there is no way of knowing the maximum size of an adverse move. But, if we are hedging against high
inflation, the investor would not be short commodities anyway.
As for the complications of delivery of the physical commodity,
the investor can overcome these by rolling their future position forward before the delivery date. For example, before the first delivery
day for the October contract, they would sell the October future, and
buy a December contract. This way, the investor maintains exposure to the rising price of cattle, while still earning interest on the
collateral.
Finally, but not least, through futures we can not only gain exposure to commodities, and resolve the issues of leverage and delivery,
but also benefit from a standardised, transparently priced, liquid
market, all of which are important considerations for any investor.
THE FIRST INVESTABLE COMMODITY INDEX
An investor worried about high inflation would want exposure not
to a single subsector or futures contract, but to a broad-based set of
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commodities, in order to get more thorough and diversified price

exposure. The first step is to identify the many commodities that
have a sufficiently liquid futures market, and establish a weighting
procedure based on relative economic importance, in terms of either
world trade or impact on inflation.
In his early work, the author chose two indexes to measure relative
economic importance: one was the ReutersCommodity Research
Bureau Price Index, which is weighted by relative volume of world
trade in each commodity; the other was the US Consumer Price Index
(CPI), which measures how both goods and services affect overall
price levels. The process required some ingenuity (and imagination),
given that not all index components of the commodity index might
be mapped to liquid future contracts and, even more challenging, a
way had to be found to deal with the services contribution to the CPI
(Greer 1978). An average of the two weighting sets resulting from
these mapping processes, summing to 100%, was taken to build the
commodity futures index.
The next step was to select the collateral to be used to back the
commodity futures index. Greer (1978) chose 90-day bank certificates of deposits (CDs),5 since he wanted to simulate a high-quality
investment, with negligible interest rate risk. To calculate returns,
the CD rate was applied to 90% of the collateral, assuming a 10%
margin requirement.
Finally, historical returns (from 1960 to 1978) for both the futures
index and the collateral were calculated at six-month intervals,6 with
the futures index rolled forward and rebalanced semi-annually. A 1%
annual transaction fee7 was also assumed. Recognising that commodities should be evaluated in the context of their impact on a
total portfolio, Greer next calculated the returns of a portfolio that
was 50% equities and 50% commodities, rebalanced semi-annually.
For 196078, the average six-month return for this balanced portfolio
was 4.2%, compared with 2.3% for stocks alone.
Note that although methodologies and computing power have
evolved since then, modern investable indexes still incorporate the
key principles established by Greers original work. In particular,
investable commodity indexes are typically characterised by
long-only, and fully collateralised, positions,
weights that reflect the relative economic importance of the
various components,
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transparent methodology for return calculation, as well as
specific rules for rolling and rebalancing the index.

THE EVOLUTION OF COMMODITY INDEXES
Although there was some additional academic research on commodity index investing in the 1980s and early 1990s (see, for example,
Bodie and Rosansky 1980; Ankrim and Hensel 1993), investors interest was minimal. Either they did not understand the nature of futures
contracts or were sceptical about the (then) novel idea of indexing.
Some might have been simply enamoured by the stocks in their
portfolios, and reluctant to venture into an area where no institutions had yet ventured. Furthermore, there was no straightforward
mechanism, such as a commodity mutual fund, which would enable
individual investors to get commodity index exposure in a practical
manner.
In fact, it was only in 1991 that the industry saw the first commercially available index, supported by a major institution, with the
launch of the Goldman Sachs Commodity Index (GSCI). In 2007,
Goldman sold its index business to Standard & Poors, so their
index is now called the Standard & Poors Goldman Sachs Commodity Index (SPGSCI). The GSCI was soon followed by indexes
supported by other investment banks. Bankers Trust began marketing the Bankers Trust Commodity Index (BTCI). Merrill Lynch began
marketing the Merrill Lynch Energy and Metals Index (ENMET).
JP Morgan started publishing the JP Morgan Commodity Index
(JPMCI). And Daiwa Securities worked with Greer to resurrect his
original index, refined to become the Daiwa Physical Commodity
Index (DPCI). The DPCI was later sold to Chase Manhattan Bank
(now JP Morgan Chase), to become, first, the Chase Physical Commodity Index, and then, the JP Morgan Commodity Futures Index
(JP Morgan, however, stopped calculating this particular index in
2000). The American International Group (AIG) also came to market
with its own version of a commodity index, the AIGCI (renamed
DJAIGCI after Dow Jones became the calculation agent). This index
was sold to UBS in 2009, after AIGs downfall, and is now offered
as the Dow Jones UBS Commodity Index (DJUBSCI). In 2009, Credit
Suisse used Greers established methodology, adapted to current
market conditions, to bring to market the Credit Suisse Commodity
Benchmark (CSCB).
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Despite the proliferation of commodity indexes in the 1990s, providers mainly sought institutional investors, who might enter into
over-the counter (OTC) swaps to get exposure to their index of
choice. Then, in 1997, the industry saw the first vehicle by which both
institutional and retail investors could get commodity index exposure, when Oppenheimer Funds launched the Oppenheimer Real
Asset Fund (now renamed the Oppenheimer Commodity Strategy
Total Return Fund), benchmarked to the GSCI.
Meanwhile, research efforts to define the characteristics of commodities as a distinct asset class, and to educate investors, were also
ongoing. Several papers were published in this period (see, for example, Greer 1997 and references therein), highlighting the difference
between traditional asset classes (such as stocks and bonds) and
commodities. The first are capital assets, which generate a stream
of cashflows and can be valued using net present value analysis. In
contrast, commodities, albeit investable, do not generate a stream of
cashflows. Their value derives from the fact that they can be consumed, and value analysis is driven mainly by supply and demand,
including estimates of future supply and demand.
Despite these efforts, commodity index investing remained somewhat limited to investment banks desks, and did not achieve mainstream status in the investment community. However, there are some
exceptions worthy of mention. There were a few early adopters of
commodities index investing, which included the Harvard endowment, the Ontario Teachers Pension Plan and two of the largest
pension funds in the Netherlands, PGGM and ABP.8 The Government Investment Company of Singapore also entered this market in
the late 1990s. However, up to the start of the 21st century, it is estimated that only about US$10 billion in capital (most of which was
institutional money, given the very few retail vehicles available) was
invested in commodity indexes.
COMMODITY INVESTING BECOMES MAINSTREAM
In the first decade of the 21st century, demand for commodity
index investment surged, accompanied by several new investment
vehicles being offered in the market. This was partly due to the
losses that equity investors suffered in 2000, making them eager
to find another area for investment. In addition, the asset class
was slowly becoming better understood, as commodity indexes
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generally had shown themselves to be a mechanism for portfolio

diversification and inflation hedging. The growth in index investments occurred at the same time that supplydemand factors were
driving commodity prices higher in several markets. This created a positive feedback loop where the satisfaction of some of
the early adopters influenced more investors to enter the market.
Because of the confluence of these factors, there was a tremendous growth in capital allocated to commodity investing, which
Barclays Capital estimated to be about US$300 billion by summer
2008.
As mentioned before, several new investment vehicles, including
mutual funds, institutional investment accounts and exchangetraded funds, were also created and received widespread acceptance.9 Some of these had broadly diverse exposure; others tracked
individual commodities or specific subsectors, and some even
owned physical commodities, most notably gold and silver.
At the same time, the growth in investments also led to a proliferation of new commodity indexes, several of which sprang
from the commodity desks of investment banks. This new set of
indexes is often referred to as second generation, compared to
the first generation represented by indexes such as the SPGSCI
and DJUBSCI. These second-generation indexes share many key
characteristics with the ones launched in the previous decades.
In particular, they include long-only, fully collateralised positions;
weights reflect the relative economic importance of the various components; they have a specific methodology and rules for rolling,
rebalancing and return calculations. However, there are also differences, as the second-generation indexes tend to have more complex rules, often based on mathematical algorithms, which might
determine in a dynamic fashion how to roll positions forward, or
how to spread exposure across several contracts on the futures
curve.
There are also some products now offered in the market which
call themselves indexes, but in fact might better be considered as
trading strategies. These products follow predefined rules, so that
their calculation is transparent, but they generally include both long
and short positions in futures markets. Such a strategy may indeed
have merit as an investment, but it may lose the inherent benefits of diversification and inflation hedging, which the asset class
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is designed to provide. In other words, even when these strategies have attractive diversification and hedging characteristics in
historical backtests (as they often do), it is doubtful whether these
results can be relied on going forward unless there is a solid fundamental explanation behind those returns. Consequently, these
long/short commodity indexes are more similar to hedge fund
strategies, seeking to produce absolute returns in the commodity
space.
COMMODITY INDEX INVESTING AS AN INFLATION HEDGE

The link between inflation and commodities is clear, as the latter have
traditionally been an important component of the basket of goods
and services used to measure inflation. In the US, for example, food
and energy comprise almost 25% of the CPI,10 and they account for
an even larger share, about 75%, of its volatility. Since it is changes
in inflation, more than absolute levels, which affect stock and bond
prices, this volatility is a major concern for investors. For instance, a
stable, predictable and relatively high rate of inflation might not be
bad for bonds, as they might still provide a nominal yield in excess of
that (the latter being a function of credit quality and other features).
But what can be devastating is an unexpected move from a low to a
high inflation regime. And in turn, material changes in inflation can
be strongly affected by commodity prices. Inflation and commodity
prices are important not only to investors but to consumers and, the
latter being voters, to politicians as well. This is especially true of
food and energy prices, which are the most visible, and politically
sensitive, component of inflation, as they can be experienced every
day at the petrol pump, and on the grocery shelf.11
Commodity index investing provides two sources of inflation
protection. One is the underlying collateral, typically invested in
short-term T-bills (providing a nominal yield spread for expected
inflation), or inflation-protected securities (guaranteeing a fixed real
return at maturity). The second is the futures index, which provides diverse exposure to changes in commodity price expectations,
including those caused by unexpected supplydemand shocks.
The fact that a commodity index strategy might be employed
to provide inflation-hedging benefits is also apparent from many
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research studies (see, for example, Cavalieri et al 2010) based on historical data. Furthermore, the fundamental link between commodities and traditional metrics of inflation (for example CPI) suggests
that these benefits should continue in the future, at least as long as
the underlying drivers of higher inflation are rooted in commodity
prices.
Of course, commodity index returns can be affected by many
factors, at times dramatically; this happened in the second half of
2008, when a deep global recession triggered a significant collapse
in prices. This highlights the added value that skilful management
can bring to commodity investing, whether in its own right, or
for inflation-hedging purposes. Clearly, dynamic markets cannot be
optimally managed, and the full diversification and hedging benefits delivered, by simply employing a mostly static index-based
strategy. Nevertheless, indexes remain an effective and transparent
way to gain exposure to commodities, as well as benchmarks of asset
class returns.
CONCLUSIONS
Commodities are key price inputs in the basket of goods and services
used to measure inflation. This relationship was brought into focus
in the 1970s, a decade during which the investment community grew
deeply aware of the negative effects inflation can have on traditional
capital assets, such as bonds and stocks.
This relationship, and the successful introduction of indexing in
equity funds, prompted the author to develop the first investable
commodity index in 1978. Investors interest, however, dwindled for
quite some time, and it was only in 1991 that the first commercially
available commodity index was launched. Over time, others followed, and a few pooled vehicles were also established in the space,
albeit the capital committed to commodity strategies remained quite
limited until the turn of the century. It was only in the next decade
that commodity investing became mainstream, with a considerable
proliferation of new indexes and investment vehicles and a virtuous
cycle of positive performance (which was interrupted, if only briefly,
by the global recession of 2008).
Since inflation remains one of the most debated issues at the time
of writing, a discussion of whether a commodity index strategy
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might provide inflation hedging is a very topical one. Indeed, commodity index investing provides two sources of inflation protection:
the underlying collateral and the futures index itself. These hedging
properties are supported by historical data, and may continue in the
future, at least as long as the underlying drivers of higher inflation
are rooted in commodity prices.
Past performance is not a guarantee or a reliable indicator of future
results. All investments contain risk and may lose value. Commodities contain heightened risk including market, political, regulatory and natural conditions, and may not be suitable for all
investors. This material contains the current opinions of the author
but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed
for informational purposes only and should not be considered as
investment advice or a recommendation of any particular security,
strategy or investment product. Statements concerning financial
market trends are based on current market conditions, which will
fluctuate. Information contained herein has been obtained from
sources believed to be reliable, but not guaranteed.
1
That is, the time of writing in autumn 2011.
The Organization of Arab Petroleum Exporting Countries (OAPEC) is a multi-governmental

organisation, with headquarters in Kuwait, which coordinates energy policies between oilproducing Arab nations. In 1973 it resolved to cut oil production in response to the US decision
to resupply the Israeli military during the Yom Kippur War. While many members of OAPEC
are also members of the Organization of Petroleum Exporting Countries (OPEC), the two
organisations are separate.
This was the First Index Investment Trust launched on December 31, 1975, now known as the
Vanguard 500 Index Fund.
This in turn resulted in the passage of Onion Futures Act of 1958 (7 USC Chapter 1, Section 131), banning the trading of futures contracts on onions.
In most modern indexes, the collateral is assumed to be invested in 90-day US Treasury bills,
but the guiding principles are analogous.
Because personal computers had not yet been invented, the gathering of data (often by hand
from microfilmed copies of The Wall Street Journal) and calculation of returns were quite
laborious, especially by modern standards.
Modern index methodologies typically assume no transaction fees.
PGGM stands for Pensioen V/d Gezondheid, Geest and Maatsch Belangen. ABP is the abbreviation for Stichting Pensioenfonds ABP, the pension fund for employers and employees in
service of the Dutch government and educational sector.
One of the largest mutual funds of this sort is the PIMCO CommodityRealReturn Strategy Fund, which invests mainly in commodity futures exposure and uses US Treasury
Inflation Protected Securities (TIPS), rather than T-bills, as collateral. The fund had about
US$27.6 billion in assets as of September 2011.
10 In some other countries, especially emerging economies, food and energy are an even larger
part of the total index than in the US.
11 In contrast, other factors, such as the price of shelter, may be a larger component of the CPI,
but they are not as obviously felt, or reported on, every day.
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REFERENCES
Ankrim, E. M., and C. R. Hensel, 1993, Commodities in Asset Allocation: A Real-Asset

Alternative to Real Estate?, Financial Analysts Journal 9(3), pp. 209.
Bodie, Z., and V. Rosansky, 1980, Risk Return in Commodity Futures, Financial Analysts
Journal 36, pp. 2739.
Cavalieri, J. R., R. J. Greer and E. Urbano, 2010, Commodities as an Effective Inflation
Hedge, PIMCO Viewpoints, October.
Greer, R. J., 1978, Conservative Commodities: A Key Inflation Hedge, The Journal of
Portfolio Management 4(4), pp. 269.
Greer, R. J., 1997, What Is an Asset Class, Anyway?, The Journal of Portfolio Management
23(2), pp. 8691.
Luttrell, C. B., 1973, The Russian Wheat Deal: Hindsight vs Foresight, Federal Reserve
Bank of St Louis Review, October, pp. 29, URL: http://www.research.stlouisfed.org/
publications/review/article/743.
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Commodities, Inflation and Growth:

Implications for Policy and
Investments
Ric Deverell, Kamal Naqvi
Credit Suisse
In this chapter, we discuss the link between commodity prices, inflation and real economic growth. We start with a review of the effect
commodity prices have on inflation, comparing and contrasting
developed and emerging markets, and analysing 2008 as a detailed
case study. Next, we discuss how higher commodity prices influence monetary policy, and compare different policy approaches from
three major central banks (the US Federal Reserve, the European
Central Bank and the Peoples Bank of China). A section discussing
the relationship between commodity prices and economic growth
follows; the key mechanisms through which commodities influence
the real economy are introduced, and the effect of growth imbalances
between developed and emerging markets is explained. Finally, we
discuss how commodity investments might be used, either to hedge
higher inflation or to lower growth. A summary section concludes
the chapter.
COMMODITIES AND INFLATION

The impact of commodities on inflation continues to be a hot topic
among academic economists and policymakers alike.1 However,
while it is clear that large movements (note that it is the change
not the level that matters most) can have a significant impact on
headline consumer price inflation (CPI), there is little consensus
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Table 3.1 Commodity prices and inflation (first half of 2008, annualised)
Food

Energy

Headline
inflation
Wt
Mature
economies
3.7
13.3
0.7
7.7
Emerging
economies
8.1
29.5
3.8
7.7
Contrib. Wt Contrib.
Non-food,
non-energy

Wt
Contrib.
1.4
79.0
1.6
0.9
62.8
3.4
Wt, weight; Contrib, contribution.

Source: BIS, OECD, Credit Suisse.
on the ultimate impact on growth and core inflation,2 or on how

policymakers should react.
When thinking about the impact of movements in commodity
prices on CPI, it is useful to consider the first round impact, and
then to assess the likely flow through to other prices, or to so-called
core inflation. Or to use the framework set out by Cecchetti and
Moessner (2008), whether headline inflation tends to revert to core
inflation, or vice versa.
The first round impact of commodity price increases on inflation is
heavily dependent on which commodity prices are increasing and
the stage of development of individual countries. In general, the
most significant impact is felt through increases in food and energy
prices, both of which form a sizeable component of CPI baskets.
While increases in basic material prices are also significant, the direct
impact on CPI inflation is more muted, as these commodities are not
directly represented in CPI baskets.3
Cecchetti and Moessner (2008) estimate the average weights
of food and energy prices in CPI in both mature and emerging
economies. As Table 3.1 shows, the first round impact of food inflation falls disproportionately heavily on emerging market economies,
with the weight of food in the average CPI basket for emerging
economies around 29.5%, more than double than the average of
13.3% for mature economies.
In addition, the impact of food commodity prices on CPI food
inflation is more muted in mature economies, where a greater share
of the food sold is processed, and thus less sensitive to changes in
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COMMODITIES, INFLATION AND GROWTH: IMPLICATIONS FOR POLICY AND INVESTMENTS
input commodity prices (the latter representing only a fraction of

consumer food prices). This means that, for any given increase in
raw commodity prices, the increase in CPI food inflation will be far
greater in emerging market countries than in developed economies
(this is why the contribution of food price increases to emerging
economies inflation is on average more than five times that for
mature economies: 3.8% versus 0.7%).
In contrast to food prices, the average weight of energy in the
consumer basket is roughly the same for both emerging and mature
economies (around 7.7%). However, while a given increase in input
food prices has a larger impact on emerging markets inflation, this
relationship is reversed with energy (compare the 1.4% for mature
economies with the 0.9% for emerging economies), as many emerging market economies subsidise energy prices to consumers. Note,
however, that these subsidies decreased in many economies in the
early 2000s, and other effects such as taxes might act in the opposite
direction (for example, in developed economies such as the eurozone, where taxes are such a high percentage of final gasoline prices
that the relative impact of raw commodities spikes is diminished).
The impact of commodities on core (ie, the CPI basket excluding
food and energy, the last two columns in Table 3.1) inflation is more
controversial. Much of the debate has focused on whether commodity price inflation should be viewed as a one-off price change or as
something that is likely to continue for some time. Of course, the
challenge is that it is not possible to tell which of these possibilities
will play out ex ante, although the state of the economy is one key
consideration, with the impact on consumer inflation likely to be
more pronounced when there is little economic spare capacity in the
system.
A simple way of assessing the impact of commodities on nonfood and energy inflation is to calculate the correlation between
movements in a broad-based commodity index and movements
in core inflation. To this end, in early 2011, Credit Suisses Chief
Economist, Neal Soss, together with Jay Feldman, assessed the correlation between annual percentage changes in the Commodity
Research Bureau (CRB) Index against the US core CPI (Soss and
Feldman 2011). They concluded that if the question is whether historically commodity price hikes have had an impact on core inflation
in the US, the answer over the past quarter century is unequivocally
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50
40
30
20
10
0
10
20
30
40
50
6
5
4
3
2
CCI (CRB) Index
US Core CPI
1988 1991 1994 1997 2000 2003 2006 2009 2012
1
0
US core CPI YoY change (%)
CCI (CRB) Index YoY change
Figure 3.1 US core inflation and commodity prices
Sources: CRB, US Bureau of Labor Statistics, Credit Suisse.
CCI (CRB) Index

50
5
US Core CPI
40
30
4
20
10
3
0
10
2
20
30
1
40
50
0
1991 1994 1997 2000 2003 2006 2009 2012
euro core CPI YoY change (%)
Figure 3.2 European core inflation and commodity prices
Sources: CRB, Eurostat, Credit Suisse.
no. Indeed, as Figure 3.1 demonstrates, the correlation coefficient

for data going back to 1985 is negative, at 37%. And a positive correlation does not emerge even by using the CRB Index to predict
core inflation in future periods (ie, using a lagged response). Soss
and Feldman go on to note that
in todays less cartelized, less unionized, more globally exposed
economy, increases in oil and food usually manifest as relative
price shocks, not generalised inflation. When prices of essentials
like food and gas go up, households are left with less free cash to
spend on other things, tending to restrain other (core) prices.
While this conclusion would not be too surprising to many in the

US, with its fabled non-unionised and deregulated labour market,
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50
40
30
20
10
0
0
10
20
30
40
1
CCI (CRB) Index
China non-food CPI
US core CPI YoY change (%)
Figure 3.3 China: non-food inflation and commodity prices
3
50
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Sources: CRB, Chinese National Bureau of Statistics, Credit Suisse.
it is also interesting that in the eurozone area, where labour markets generally remain more heavily unionised and regulated, similar conclusions can also be reached. In fact, since 1991, when the
European Union started publishing combined eurozone inflation
data, the correlation between annual changes in the CRB Index and
eurozone core (again excluding food and energy) inflation has been
negative, in this case 0.27%, suggesting that, as in the US, commodity price spikes negatively affect relative prices in other consumer
sectors, rather than permanently increasing overall inflation by raising inflation expectation, wages and other non-commodity prices
(Figure 3.2).
This analysis suggests that, while large movements in commodity
prices can have a significant impact on headline inflation in the short
run, there is little clear evidence of significant sustained (long-term)
impact on either core or non-core inflation in the US and Europe, at
least in recent history. This is in line with Cecchetti and Moessner
(2008), who also conclude that4
in recent years, core inflation has not tended to revert to headline,
which suggests that higher commodity prices have generally not
spawned strong second-round effects.
While the results of correlation analysis in mature economies are

unequivocal, there is considerable divergence in the results for some
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80
60
40
20
0
20
China***
India**
Brazil
Eurozone
Indonesia*
US
Czech Rep
Chile
60
Poland
40
Korea
YoY Correlation with CCI (CRB)

and Core CPI (%)
Figure 3.4 Correlation of core inflation with commodity prices
Indonesia from 2003, interpolating June 2008 to November 2008; India using
WPI; China using non-food CPI (see also endnote 5).
Sources: CRB, Press Information Bureau of India, Eurostat, US Bureau of Labor
Statistics, NBS, Credit Suisse.
emerging economies, with China and India (Figures 3.33.4) showing a relatively high positive correlation between movements in the
CRB Commodity Index and core inflation since around 2009.5
This suggests that the impact of higher commodity prices on core
inflation is substantially higher in some cases, or, using Cecchettis
(2008) framework, that core inflation has tended to revert to headline
inflation in economies such as China and India. However, note that,
in the case of China, the positive correlation might be overstated,
given that the short sample period is dominated by the global recession of 20089, when most prices moderated substantially. In the
following section, we shall elaborate on these points and analyse
what happened in 2008, and give potential explanations for these
positive correlations.
WHAT HAPPENED IN 2008?
In the 18 months from January 2007 to June 2008, the US dollar price
of oil increased by 135%, while the price of food (as measured by
the United Nations Food and Agriculture World Food Price Index)
increased by 65%. In the 12 months from July 2007 to June 2008, the
average US dollar price of oil increased by 95%, while food prices
increased by 44%. The direct impact of food inflation was greater
than that of energy in both emerging and mature economies. It is
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Figure 3.5 Food and energy contribution and share of CPI (first half of
2008, annualised)
Food
Energy
9
8
7
6
%
5
4
3
2
1
0
Mature
economies
Emerging
economies
Non-food and non-energy

100
90
80
70
60
% 50
40
30
20
10
0
Mature
economies
Emerging
economies
Sources: BIS, Credit Suisse.
striking, however, that food contributed significantly more to inflation in emerging economies than that in mature economies. It is also
notable that despite being the same weight in CPI baskets, energy
prices had a far larger impact on CPI inflation in mature economies
than that in emerging economies.
Figure 3.5 shows clearly that in mature economies 55% of the
increase in inflation in this period was attributable to food and
energy prices (the key commodity drivers), with only 45% arising from core inflation. For emerging markets, 57% of inflation
comes from food and energy, and 43% from core inflation. This
should not be terribly surprising given the far greater weight of food
and energy components in the average CPI basket in the emerging
markets (nearly 40%) compared with about 20% on average across
mature economies (Table 3.1). Notably, while food and energy prices
made a significant contribution to inflation in emerging economies,
the contribution from core inflation was much higher in these
economies. These findings, coupled with the higher correlation
between commodity prices and core inflation, suggest that commodity price inflation is more of an issue for emerging economies than
developed ones.
For emerging (but not for mature) markets, empirical evidence
shows that commodity prices, and food in particular, have had an
impact on core inflation. However, even in those cases, the increase
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has not been structural in nature (at least since 1998) as higher core
inflation has reverted to previous (lower) levels in line with the
subsequent stabilisation (or fall) in commodity prices.
INFLATION AND MONETARY POLICY
When assessing the likely monetary policy response, a key question
is whether commodity price inflation is mainly driven by supply
(like the oil crisis in the 1970s) or demand shocks. For example, in the
case of food prices, the predominant cause has typically been supply disruptions,6 due to droughts, floods and crop diseases. While
these disruptions can affect food prices for some time, they generally
self-correct in the medium to long run. Instead, in the first decade
of the 21st century, much of the increase in oil prices was driven by
stronger than anticipated demand, although supply shocks (such as
the one experienced in early 2011) remain a real risk, particularly in
the light of political turmoil in producing countries in North Africa
and the Middle East. For basic materials, the predominant cause of
prices trending up (35% for copper and 100% for iron over the first
decade of the 21st century) was stronger than anticipated demand,
driven by China and other countries. Such demand-side fundamentals are likely to remain the main driver of basic metals prices for
the foreseeable future. In summary, commodities price movements
in the first decade of the 21st century have often had very different
drivers from the oil supply shock of the 1970s.
An important question is whether the increase in prices is likely
to be permanent or temporary (such as a one-off price adjustment),
although in practice it is difficult to assess which one of these will be
ex ante. To the extent that changes are driven primarily by temporary
factors (such as most supply shocks), many central banks would be
expected to look through the impact when setting monetary policy. This is partly because monetary policy has very little impact
on factors such as food prices. But it is also because, by the time
monetary policy can reasonably have begun to affect broader prices
(given the long and variable lags), the price change is already likely
to have reversed. The objective of monetary policy is not to control
short-term inflation fluctuations but to make sure that, on average,
inflation remains within an acceptable range. On the other hand,
when changes in commodity prices are driven by a demand shock,
they are likely to prove more resilient, increasing the likelihood that
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policymakers will indeed intervene. Given the difficulties in assessing the effects of all of these factors, several central banks tend to
focus on inflation expectations. If the latter remain well anchored,
there is scope for monetary policy to look through a (likely) temporary period of higher inflation, primarily because firms and consumers are doing the same. This said, and for a variety of reasons
(some related to differences in the specific countrys inflation process, and some related to cultural and historical norms), it is clear
that there are significant differences in how the major central banks
assess inflation and react to a change in commodity prices. For example, at least historically, the US Federal Reserve has not been overly
concerned about the effect of higher commodity prices on headline inflation, as long as core inflation remained well behaved. This
stance is likely to be reaffirmed, given the relatively low level of core
inflation and large output gap (extra capacity in the economy) at the
time of writing. In contrast, the European Central Bank (ECB), and
before that the Deutsche Bundesbank, has had an explicit headline
inflation target. The ECB will tighten monetary policy if headline
inflation moves above its target because of commodity prices, even
if the move is likely to be transitory. The Peoples Bank of China has
generally adopted a flexible and pragmatic approach, using monetary policy in order to ensure that commodity price inflation (particularly food inflation) does not unduly affect core prices and inflation
expectations.
COMMODITIES AND GROWTH
As with inflation, the impact of commodity prices on the macroeconomy, and real growth in particular, has been the subject of much
academic research. However, while there are many articles on the
topic, most of the literature is heavily focused on oil and the impact
on the US economy.7 As Rasmussen and Roitman (2011) point out
in a recent IMF working paper, there has been much less work on
other countries and very little of that on developing economies.
In addition, most of the research focuses exclusively on the impact
of oil.
There are two key mechanisms that are discussed when assessing
the impact of commodities inflation on economic growth. The first
is that an increase in commodity prices can lead to higher inflation
and therefore result in tighter monetary policy than would otherwise
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have been the case. This would in turn reduce the pace of economic
growth. The second is that higher commodity prices can act as a
tax on consumers and business, lowering profits and reducing consumption and investment. While there is merit in both arguments,
as often in economics, both rely on strong assumptions, which are
not likely to hold consistently over time.
On the first point, while there is no doubt that rapid increases in
commodity prices can result in higher inflation, the policy response,
if any, is likely to vary significantly depending on the stage in the
economic cycle, and each specific countrys approach to monetary
policy. For example, in 2011 the increase in commodity prices proved
far more problematic for emerging economies, where the commodity weight in inflation baskets is larger and where there is little spare
capacity. In contrast, in mature economies such as the US, commodity inflation has been fairly inconsequential for policymakers, in
view of the large output gap and slow economic growth.
On the second point, while there is much focus on higher commodity prices being a tax on consumers, this effect has been most
relevant in developed markets, and in the US in particular. From a
global perspective, movements in commodity prices are by definition a zero-sum game, with some countries (or corporations) benefiting from higher revenues, while others face the opposite side of the
coin. While there will be frictional issues, as the negative effect on
consumers will manifest in less time than is required for the beneficiaries of higher prices (be they corporations or countries) to translate
higher incomes into higher investments and growth, the ultimate
impact at the global level should be one of distribution rather than
creation or destruction of wealth. Therefore, it is a mistake to focus
only on the cost-side impact of higher commodity prices, especially
in an increasingly globalised economy. For example, while higher
commodity prices might indeed impact negatively on consumers
and producers in G7 economies, many of those same consumers
may own shares in multinational commodity companies, and may
stand to benefit directly from higher equity valuations and higher
dividend payments.
As the global economy continues to recover from the Great Recession of 20089, the distributional issues related to higher commodity prices in the macroeconomy are likely to be more pronounced
than normal. In simple terms, many of the countries that benefit
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most from higher commodity prices are emerging markets (Saudi

Arabia, Brazil, etc; Canada and Australia are notable exceptions),
and their economic growth has rebounded strongly following the
Great Recession. Given that these economies have little spare capacity, local monetary authorities have generally tightened policy by
raising interest rates to avoid inflationary pressures, as there is little
scope for output to expand further. In contrast, many of the countries
where economies remain fragile, primarily Japan, EU member states
and the US, have experienced the negative impact of higher prices.
In these countries, the severe recession was followed by disappointingly anaemic growth. This in set the stage for an environment
where higher prices (oil in particular) have had the most negative
impact on consumers behaviour and curbed both spending and economic growth significantly. In other words, the imbalance between
growth in emerging and developed economies has increased the
impact of higher commodity prices on global growth to more than
just a distributional issue. Emerging markets have already grown
close to or exceeded capacity and have been trying to slow their
economies in the face of higher commodity prices and the threat
of inflation. Developed markets face the negative impact of higher
prices on top of fragile economies, with few tools in the policy
arsenal to boost growth, as interest rates are already at historical
lows and quantitative easing measures have had only a temporary
effect.
In regard to the impact of higher energy prices, Rasmussen and
Roitman suggest that
the negative impact of oil price increases depends to a large extent
on, first, how dependent countries are on oil imports, and, second,
how strong are their links to oil exporters and the rest of the world.
Interestingly, the US appears to be an outlier, with the real economy

relatively sensitive to movements in oil prices despite the fact that oil
imports are relatively small. This is likely to be due to lower gasoline
taxes in the US than most other advanced economies, which means
that movements in oil prices affect the retail price of gasoline much
more substantially. Also, because the gasoline price is typically lower
in the US than in most developed countries, such as EU member
states, the average American consumes far more gasoline per capita
than their European counterpart and thus is more directly affected
by higher prices.
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Figure 3.6 Mining investments in Australia as a percentage of GDP
Mining as share of GDP (%)
10
8
Forecast
6
4
2
0
1860
1880
1900
1920
1940
1960
1980
2000
Sources: Reserve Bank of Australia, Credit Suisse.
As mentioned before, there are also beneficiaries of higher commodity prices. Some examples are the oil-exporting countries and
Australia. The latter is an interesting case, with higher commodity
prices resulting in a massive surge in mining investment (Figure 3.6),
which is likely to continue. The interesting thing is that this sort of
investment is capital and import intensive, and our ballpark estimate
is that approximately half of the value added will be from imports.
Consequently, while the impact from higher commodity prices is
a tax on consumers in the US, many American companies will be
clear beneficiaries from greater exports, which will support mining
investments in Australia.
The behaviour of oil exporters such as Saudi Arabia will also be
key for the net global impact of higher commodity prices on growth.
In the five years from 2003 to 2008, the massive increase in oil revenues to the Middle East and North Africa (MENA) was primarily reinvested in the US bond market, contributing to the low-rates
conundrum during the period. In this case, higher capital from oil
revenues was not spent on goods and services but invested in US
bonds. In other words, investment of MENA oil revenues in the US
bond market flattened the yield curve and resulted in looser credit
conditions than would otherwise have been the case. Given the significant political unrest in the MENA region in 2011, the more likely
outcome is that the countries from the region will spend a larger
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proportion of oil revenues on building infrastructure and supporting social programmes domestically. In turn, this may still benefit other countries, since imports of both consumer and investment
goods from developed markets into MENA are likely to increase
substantially.
Another key factor when considering the impact of higher commodity prices on the real economy is the underlying cause of the
increase in prices. If commodity prices are rising because of stronger
demand, as is the case for most non-corn agricultural commodities, it
is unlikely for economic growth to slow substantially. If, on the other
hand, higher prices are the result of a supply shock (as occurred in
the 1970s and early in 2011), the impact on growth is likely to be
more substantial.
COMMODITIES INVESTING
As highlighted above, commodity prices are affected by and have an
effect on both inflation and real economic growth. In the following,
we shall briefly explore how commodity investments can be used to
exploit these relationships with inflation and real economic growth.
Commodity investments and inflation
The market for inflation protection has grown markedly. As an example, the inflation-linked bond market has reached a notional size of
over US$1.5 trillion, and other inflation sensitive assets such as property, infrastructure and commodities have all attracted investors
attention specifically due to their inflation-hedging characteristics.
Despite the evidence that it is emerging markets investors that
have the most to gain from an investment in commodities as a
hedge to inflation, it has been developed market investors that have
most commonly cited inflation as the basis for their investment in
commodities. This may be in part a reflection of different investment approaches, with emerging market investors typically having
an absolute return objective, and developed market institutional
clients typically following a more diversified portfolio approach.
For the latter, indexes consisting of commodity futures, such as the
Standard & Poors Goldman Sachs Commodities Index (SPGSCSI),
Dow Jones UBS Commodities Spot Index (DJUBSCI) or Credit Suisse
Commodity Benchmark (CSCB), have become the most commonly
used investment vehicles to gain exposure to commodities. Such
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indexes use liquid, transparently priced futures contracts and follow a specific weighting and trading methodology. Importantly, they
can be back-tested: for example, the SPGSCI has been tradeable since
1992, although in academic studies researchers have reconstructed
the index going back to 1959 (Chapter 2).
Commodity indexes saw significant evolution in the early 2000s,
and at the time of writing a range of them incorporate features
such as yield optimisation, thematic weighting or dynamic active
elements. These indexes are also highly customisable, conditional
on the liquidity of the underlying commodities, with country or
regional inflation weighting being offered by several banks. As an
example, Credit Suisse has built and traded an index, the Credit
Suisse Commodity Benchmark China Index, of those commodities that are most sensitive to commodity demand from China.
There are, of course, other ways in which commodity exposure can
be obtained. An investor may choose to trade commodity futures
directly, although this requires knowledge of both the fundamentals and technical characteristics of each specific commodity sector.
More commonly, investors (and retail investors in particular) take
exposure to a customised commodity basket, through a structure
providing derivative exposure to specific commodities over a set
period of time (and sometimes capital protection). Although these
structured investments can be tailored to the specific investor, they
tend to be significantly less liquid and lack the transparency of a
plain vanilla commodities index.
There is an active debate about whether to invest in commodityrelated equities or directly in the underlying commodities. This is
not a black-and-white debate, as there will be certain situations
when one or the other will be the better choice. That said, over the
first decade of the 21st century, the rise in extraction and development costs, widespread geopolitical risks, the popularity of resource
nationalism and a raft of natural disasters have demonstrated that
the ability of a resources company to grow profitability consistent
with rising gross revenue from higher commodity prices is debatable. In turn, this has resulted in a shift towards direct commodity
investments.
This shift has been aided by the development of Exchange Traded
Products (ETPs) offering commodity exposure. These vehicles have
allowed a much wider cross-section of investors to gain commodity
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exposure as effortlessly as buying an exchange-traded stock. Indeed,

by mid 2011, SPRD Gold Shares,8 an exchange-traded fund (ETF)
backed by gold, had become the largest exchange-traded fund, surpassing more conventional ETFs tracking equity indexes such as the
S&P 500. The trend towards direct commodity investing has become
firmly established in North America and Europe, but this remains a
relatively new development in the Middle East, South America and
Asia. Given the key impact of commodity prices in these economies,
interest for commodities has grown substantially. In our opinion,
there is considerable potential for growth in commodities investing
in these emerging markets, although investors are likely to adopt a
more regional focus, investing in local commodities, conditional on
their liquidity.
Lastly, a discussion on commodity investing and inflation is
not complete without an explicit mention of gold. Gold has seen
renewed interest as an investment asset in its own right in the early
2000s, with inflation expectations often being cited as one of the
major drivers for such interest. Although empirical evidence in support of gold as an inflation hedge is not that strong, gold is generally
perceived as a defensive asset. Whether its hedging characteristics
will be reaffirmed by future performance remains to be seen, especially in light of the volatile and uncertain market environment we
are likely to experience in the foreseeable future.
Commodity investments and growth
In addition to the traditional role of commodity investments as inflation hedges, a trend has emerged in which investors take commodity
exposure as a way of hedging negative shocks to economic growth
that might result from higher commodity prices (oil in particular).
For example, out-of-the-money calls on oil have been employed in
this capacity, as a way to acquire protection against such tail events.
The realisation that commodity prices may be not only a beneficiary
of growth but also a risk to growth has significantly expanded the
number of potential investors in commodities, a trend that is likely
to continue thanks to persistent market volatility. As noted before,
supply-type shocks are more likely to negatively affect growth, and
thus produce scenarios where even commodity-related equities may
not provide an effective hedge to higher prices (and lower growth).
As explained before, the impact of commodities on growth is
country specific, and differs for emerging and developed markets.
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Other, more subtle, factors are also important. For example, in the
US, oil might be a greater challenge to growth (and equity prices),
while in China agricultural prices might pose the greatest risk. Thus,
it is unlikely that any global commodities index will provide the
best solution for all. Rather, the appropriate vehicle (be it a specific
commodities basket or some other commodity derivative structure)
needs to be tailored to the specific needs and views of the investor.
CONCLUSIONS
In this chapter, we have analysed the connection between commodity prices, inflation and economic growth. We discussed the different
factors influencing developed and emerging markets, in particular
the effect of food and energy prices on headline inflation and the
correlation between commodity prices and core inflation, and how
these depend on the underlying cause of commodities inflation, ie,
whether the price change results from a supply or demand shock. We
also discussed the likely monetary response. Finally, we discussed
commodity investments either as a way to hedge shocks in overall
prices, ie, inflation, or for economic growth.
1
See, for example, Cecchetti and Moessner (2008), Fry et al (2009), Hobijn (2008) and Lipskey
(2008).
In this chapter, we generally use the exclusion method when calculating core inflation,
which simply excludes energy and food from the basket of services and goods. However,
this is done for simplicity, given that other statistical measures such as trimmed mean and
weighted median generally give a better feel for the underlying tendency of inflationary
pressures.
The direct first-round impact of commodity price changes on most finished goods is generally
small. For example, for laptop computers and mobile telephones it is a tiny fraction, while for
US-made cars it is less than 10% of final sale price (pension obligations, in contrast, account for
as much as 25%). For residential apartments, the total cost of raw materials (steel, aluminium,
copper, etc) is generally less than 10% of the cost of construction, and an even smaller fraction
of sale price (developer margins are generally greater than raw material costs).
Similar conclusions are drawn for Australia in a 2010 study conducted by Norman and
Richards (2010), who find little evidence that either commodity prices or the growth rate
of money directly influence Australian underlying inflation.
Note that there are some limitations on data. China has published a core measure of inflation
only since 2006, while India does not publish a CPI. We have therefore used the Wholesale
Price Index for India.
While supply disruptions have been the predominant short-term cause of spikes in food prices
in the early 2000s, it is possible that over time increased demand from emerging markets could
slow or even halt the long-term downwards trend in food prices evident at least since the
beginning of the 20th century. In addition, government policies can have an impact. For
example, the introduction of ethanol mandates in the US has directly contributed to the
doubling of global corn consumption growth, from 0.8% per year in the period 19752003, to
1.6% per year since then. This policy is likely to lead to higher food prices over coming years
(all other things being equal).
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See, for example, Hamilton (1983, 1996, 2005, 2009), Bernanke et al (1997) and Blanchard and
Gal (2007).
See http://www.spdrgoldshares.com (ticker: GLD).
REFERENCES
Bernanke, B., M. Gertler and M. Watson, 1997, Systematic Monetary Policy and the
Effects of Oil Price Shocks, Brookings Papers on Economic Activity 28(1), pp. 91157.
Blanchard, O., and J. Gal, 2007, The Macroeconomic Effects of Oil Price Shocks: Why
are the 2000s So Different from the 1970s?, NBER Working Paper 13368.
Cecchetti, S., and R. Moessner, 2008, Commodity Prices and Inflation Dynamics, BIS
Quarterly Review, December, pp. 5566.
Fry, R., C. Jones and C. Kent (eds), 2009, Inflation in an Era of Relative Price Shocks,
in Proceedings of Reserve Bank of Australia Conference 2009, Kirribilli, NSW, URL: http://
www.rba.gov.au/.
Gorton, G., and K. Rouwenhorst, 2005, Facts and Fantasies about Commodity Futures,
Working Paper 04-20, Yale Information Center for Finance.
Hamilton, J., 1983, Oil and the Macroeconomy since World War II, Journal of Political
Economy 91(2), pp. 22848.
Hamilton, J., 1996, This Is What Happened to the Oil Price/Macroeconomy Relation,
Journal of Monetary Economics 38(2), pp. 21520.
Hamilton, J., 2005, Oil and the Macroeconomy, in S. Durlaf and L. Blume (eds), The New
Palgrave Dictionary of Economics, Second Edition (London: MacMillan).
Hamilton, J., 2009, The Causes and Consequences of the Oil Shock of 200708, NBER
Working Paper 15002.
Hobijn, B., 2008, Commodity Price Movements and PCE Inflation, Federal Reserve Bank
of New York Current Issues in Economics and Finance 14(8), pp. 17.
Lipskey, J., 2008, Commodity Prices and Global Inflation, Speech to International Monetary Fund, May, URL: http://www.imf.org/external/nap/speeches/2008/050808.htm.
Norman, N., and A. Richards, 2010, Modeling Inflation in Australia, Discussion Paper
RDP 2010-03, Economics Analysis Department, Reserve Bank of Australia, Sydney.
Rasmussen, T., and A. Roitman, 2011, Oil Shocks in a Global Perspective: Are They Really
That Bad? Working Paper WP/11/194. International Monetary Fund.
Soss, N., and J. Feldman, 2011, Commodities and Core CPI: As Dead as Disco, US
Economics Digest, February 17.
Stevens, G., 2008, Commodity Prices and Macroeconomic Policy: An Australian Perspective, Reserve Bank of Australia Bulletin, June, URL: http://www.rba.gov.au/.
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Inflation and Real Estate Investments
Brad Case; Susan M. Wachter

National Association of Real Estate Investment Trusts (NAREIT);
The Wharton School, University of Pennsylvania
In this chapter we analyse the inflation sensitivity of real estate investments, comparing them to other inflation-sensitive assets. The
most transparent source of real estate investment returns comes
from publicly traded stocks of real estate investment trusts (REITs).
We examine the available return data, with an emphasis on their
relationship to US inflation, although our conclusions may apply
elsewhere as well.
Consumer price inflation (CPI) in the US was 13.5% during 1979,
the worst year since 1947. Dividend income from REITs traded
through the stock exchange averaged 21.2% that year, and total
returns amounted to 24.4%, not only preserving but increasing for
REIT investors the purchasing power that they had lost to inflation.
Inflation averaged 11.6% per year during 197880, the worst threeyear period in six decades; again, however, publicly traded equity
REITs outpaced inflation, with income and total returns averaging
12.2% and 23.1% per year, respectively. The period 197481 was the
most inflationary eight years in the history of the Consumer Price
Index at 9.3% per year, but equity REIT returns easily preserved purchasing power, with income and total returns averaging 10.2% and
16.3% per year.
During the first eight months of 2011, annualised consumer price
inflation was 5.1%. Again, equity REIT returns protected purchasing power, with annualised total returns averaging 8.4%. However,
dividend income, during a period of extraordinary weakness in real
estate operating fundamentals, fell short of inflation at 3.4% per year.
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The rate of growth of equity REIT dividend payments averaged

7.71% per year from the beginning of 1978 up to and including
August 2011, while consumer price inflation over the same period
averaged just 3.92%, and equity REIT dividend income exceeded the
inflation rate in 306 of the 404 individual months during that historical period. Thus, over this entire period, REIT returns preserved
purchasing power. This of course raises the question of how well
REITs hedge inflation during sub-periods and in comparison with
other assets.
In the analysis that follows, we compare real estate investments
to other inflation-sensitive assets, and point out that the common approach to evaluating sensitivity, by computing correlation
between asset returns and inflation, fails to address directly the
question of whether returns from a given asset actually protect consumers from loss of purchasing power. The relevance of this fact
stems from the observation that many investors do not hedge their
exposure to inflation formally by computing the optimal hedge ratio
and acquiring long or short positions to implement the hedge; rather,
they typically rely on some informal combination of strategic and
tactical asset allocation, deploying capital into asset classes that are
expected to perform well during inflationary regimes, and doing so
more aggressively when high inflation is anticipated.1
In response to this observation, we employ a direct measure
of the effectiveness of the passive inflation protection provided
by a given asset. We also note that, given the difference in asset
returns in high- versus low-inflation periods, choosing a tactical
asset allocation specific to a high-inflation regime exposes investors
to considerable directional risk. A balanced approach that provides similar risk-adjusted returns in both low- and high-inflation
regimes may be preferable for investors who do not possess superior
inflation-forecasting abilities.
In addition to investing in commercial real estate through ownership of stock in publicly traded equity REITs, investors can also
invest in illiquid real estate assets such as shares in private equity
real estate investment funds (including non-listed equity REITs) or
direct ownership of properties. In this chapter we note the substantial pitfalls of using return estimates based on appraised property values for evaluating inflation sensitivity of illiquid assets, and
review the available evidence on illiquid real estate as an inflation
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INFLATION AND REAL ESTATE INVESTMENTS
hedge. Finally, we consider why certain property types may be more

sensitive to inflation than others, and review evidence on inflation
sensitivity by property type.
REAL ESTATE AS A HEDGE AGAINST INFLATION
We begin by considering conceptually the extent to which real estate
can be expected to hedge against inflation. The Gordon growth
model suggests that real estate can be considered a perfect hedge
against inflation (unlike, for example, most fixed-income products)
because real estate is a long-lived asset with income that adjusts to
inflation (Gordon 1962). The model, despite its obvious limitations,2
clearly illustrates this relationship. Real estate asset prices (and, similarly, REIT equity prices) are given by the net present value (NPV)
of the future rent cashflow stream, which is assumed to grow indefinitely at a constant rate g and is discounted by the appropriate
nominal rate r
real estate price = NPV(future rent income)
=
next period rent

rg
REIT equity price = NPV(future dividends)

=
next period dividend

rg
Assuming no change in the real economy,3 inflation will affect the

discount rate r and the rent (equity dividend) growth rate g in
equal measure, and thus will have no impact on capitalisation rates
in inflation-adjusted terms, or on real estate asset values. In other
words, the inflation-adjusted return from holding real estate assets
is invariant to inflation, at least in this simple model. Of course, models aside, the question needs to be tested, and settled, by empirical
evidence, which we shall do in the following sections.
Real estate prices may, of course, change in response to several factors other than inflation itself, and these may be difficult to isolate
in the empirical analysis. Most notably, exogenous supply/demand
shocks (as well as endogenous cycles within the real estate market)
will affect asset prices as well as imputed rents (or, equivalently,
the growth rate g) differently. Specifically, positive demand shocks
will tend to increase real estate asset prices and rents, while positive supply shocks (which increase costs) will act in the opposite
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direction. For example, as discussed below, energy-related supplyshock inflation episodes such as the oil shocks of the 1970s will affect
real estate returns differently from demand shock inflation deriving
from either monetary or fiscal policy. Moreover, over the real estate
cycle, the inflation-adjusted return of real estate assets will increase
when real estate assets are in demand, and decrease when supply is
plentiful.
In practice, although many REITs have contractually specified
step-up clauses, actual responsiveness of rents, especially to shortrun and intermediate-run effects associated with shocks and cycles,
tends to be dampened by the use of leases.4 As typical lease structures differ by property type, the dampening effect on rent adjustments will also differ: a topic that will be investigated empirically
later in the chapter.
Another conceptual issue that we briefly consider here relates to
the debt structure of real estate investments. It is plausible to assume
that, if an asset were to be financed with long-term fixed-rate debt,
higher inflation would be beneficial to the liabilities of the real estate
owner, as the loss to the debt investor is mirrored as a gain to the borrower. This suggests an empirically testable hypothesis: REITs holding relatively large amounts of long-term fixed-rate debt will tend
to have stronger returns than REITs holding small amounts of longterm fixed-rate debt, during periods of high inflation. Unfortunately,
while data on total debt is readily available through sources such as
SNL Financial,5 data on the composition of debt (long-term versus
short-term, and fixed-rate versus variable-rate) is more difficult to
collect consistently, which is why we have only briefly examined
this here.
As a proxy for detailed information on REIT use of debt, we identified 41 equity REITs that generally used relatively high leverage
and 41 that generally used relatively low leverage, and compared
their returns during months of high versus low inflation during the
period 19912010, where high-inflation months were identified relative to the median monthly CPI over the study period. The empirical
data supports the hypothesis, though not strongly enough to reject
the null: the median monthly total return of high-leverage REITs
(1.26%) exceeded that of low-leverage REITs (1.16%) during months
of higher-than-median inflation, but fell short (1.05% versus 1.76%)
during months of lower inflation.6
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Having considered conceptually how real estate can be thought

of as a hedge against inflation, in the remainder of this chapter we
develop empirical techniques for analysing the inflation sensitivity
of real estate assets.
HEDGE EFFECTIVENESS AND INFLATION SENSITIVITY
An approach to evaluating the relationship between investments
and inflation that is fairly standard in the investment community
(although less so in the academic literature) is to compute the contemporaneous correlation between inflation (eg, change in consumer
price inflation, available monthly) and asset returns at the same frequency (cf. Bhardwaj et al 2011; Lomelino et al 2011; Ralls 2010). A
correlation approaching 100% is considered a sign of high sensitivity
to inflation, and therefore of an asset with good inflation-hedging
properties.
There are three problems with this standard approach, as applied
by investors and investment advisers (many of whom do not hedge
but rather use strategic and tactical asset allocation to protect against
inflation). First, the correlation coefficient gives equal weight to all
historical periods without regard to whether inflation was high or
low in those periods, whereas many investors seek inflation protection specifically during periods of high inflation. Possible solutions to this problem include computing a semi-correlation coefficient using data from only those months in which inflation was
relatively high, or weighting each month according to the level of
inflation during that month.
Second, use of the contemporaneous correlation implies that only
those assets whose returns respond to inflation during the same
month are of value to investors as inflation protection. Returns of
some assets, though, may be sensitive to inflation with a lag, especially when inflation is unexpected. For example, even US Treasury
Inflation Protected Securities (TIPS), which provide income explicitly linked to realised inflation through a monthly adjustment to the
bond principal, have a two-to-three month lag in their indexation
to CPI.7 Note, however, that the market price of TIPS will respond
in synchronicity with changes in relevant market variables, most
notably (real) interest rates (which in general will display correlation with inflation). Because of this, the investors horizon remains a
relevant empirical issue in the study of inflation sensitivity; ways to
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address this issue include computing the correlation between asset

returns and lagged inflation, developing a distributed-lag model of
the relationship between inflation and asset returns and estimating
a vector autoregression (VAR) model of the same relationship.
Third, the correlation coefficient is a measure of co-movement
but not a measure of whether returns preserve purchasing power
or provide what we term here an effective inflation hedge. That
is, correlation measures whether asset returns move in the same
direction as inflation, but to establish an effective inflation hedge
the correlation coefficient needs to be used as an input, along with
the volatilities of different asset returns, to compute the appropriate
hedge ratio.8 In practice, the stability of the correlation coefficient is
often the most challenging aspect in determining the optimal hedge
ratio and employing a hedge strategy.
As an alternative to the optimal hedge ratio, then, investors
may consider other forms of inflation protection. One approach
is to establish a strategic portfolio allocation with significant positions in assets that preserve purchasing power during high-inflation
regimes; in the next two sections we introduce a direct measure
of inflation-protection dependability based on the success rate of
a given asset in accomplishing this goal, and test the findings
for robustness. A strategic allocation appropriate to high-inflation
regimes, however, may produce poor returns during low-inflation
regimes. In the following sections, we consider the opportunities and
risks inherent in a strategy of shifting tactically between portfolios
optimised for high- and low-inflation scenarios, and suggest an
approach towards developing a strategic portfolio balanced between
optimal performances in both inflation regimes.
EFFECTIVENESS OF TACTICAL ASSET SELECTION FOR
INFLATION PROTECTION
A fundamental problem with using correlation to evaluate the inflation protection provided by an investors choice of asset classes is
that the correlation coefficient measures whether asset returns comove with inflation (and therefore its value as an input in developing an optimal inflation hedge), not whether they protect directly
against inflation, in the sense of protecting against purchasing power
loss. In order to develop a direct measure of inflation protection, we
propose the following process.
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Figure 4.1 Distribution of annualised six-month CPI rates

100
87
Number of observations
90
83
80
70
60
53
51
50
40
30
20
26
16
18
15
7
10
0
14
<0
12
34
56
78
18
6
910
11+
Inflation rate bucket (%)

Source: US Bureau of Labor Statistics data.
(i) Define the investment horizon over which inflation protection

is desired: in our analysis, a six-month period. Our study covers the window from January 1978 to August 2011, thus including 399 overlapping9 semesters summarised in Figure 4.1.
Among the 399 observations in our sample, the median annualised inflation rate was 3.2%. In the following section, we
shall also consider how the results change if inflation protection is measured at different horizons (monthly, bi-monthly,
annually).
(ii) Specify the inflation scenarios under which protection is
sought. Our analysis focuses on high-inflation periods, defined
as semesters during which annualised inflation exceeded 3.2%,
our samples median. By construction, half of the observations in our data set satisfy this criterion; of course, other
demarcation lines are possible, as discussed in the following
section.
(iii) Define how to measure the effectiveness of inflation protection. We use the success rate: that is, the relative frequency
with which returns equalled or exceeded inflation during
the 199 semesters of high inflation in our sample, thereby
accomplishing the usual goal of protecting purchasing power.
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Table 4.1 Inflation protection success rate (%)

Success rate (%)
REITs
Commodities
Stocks
TIPS
Gold
65.8
70.4
60.8
53.8
43.2
Source: FTSE NAREIT All Equity REITs Index, S&P Goldman Sachs Commodity Index, Ibbotson Associates US TIPS, Barclays Capital US Treasury
TIPS Index, S&P 500 Index, S&P GSCI Gold Index.
Table 4.1 presents the proposed measure of inflation protection using six-month periods constructed from monthly data for a
selection of five asset classes:
1. publicly traded equity REITs, measured by the FTSE NAREIT
All Equity REITs Index;
2. commodities, measured by the S&P Goldman Sachs Commodity Index (GSCI);
3. TIPS as measured by the Ibbotson Associates synthetic US TIPS
series, which is equal to the Barclays Capital US Treasury TIPS
Index from January 1997 onwards, but is backfilled by Ibbotson
prior to that;10
4. US equities, as measured by the S&P 500 Index;
5. gold as measured by the S&P GSCI Gold Index.11
All indexes measure total returns (ie, income plus price appreciation).
As Table 4.1 shows, the two assets providing the most dependable
inflation protection (by our measure) were commodities and equity
REITs, with commodities providing total returns that equalled or
exceeded inflation during 70.4% of high-inflation semesters and
equity REITs close behind at 65.8%. Stocks and TIPS provided somewhat weaker inflation protection by this measure, with stocks protecting purchasing power during 60.8% of high-inflation six-month
periods and TIPS even lower at 53.8%. By our measure, the weakest inflation protection among this group of assets was provided by
gold, which successfully protected purchasing power during only
43.2% of high-inflation six-month periods.12
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As a note of caution in interpreting these results going forward,

we stress that one key issue to choosing an asset class for tactical protection against inflation is not just forecasting correctly high (or low)
periods of inflation, but having insight on the specific cause driving
prices higher (or lower). For example, if inflation is caused by higher
energy costs through an oil supply shock, it is plausible that energy
commodities will be the winning sector in terms of tactical allocation (and later be the losers when the price spike corrects itself). This
might not be true in the case of a dis-anchoring of inflation expectations driven by ineffective monetary or fiscal policies. This caveat
applies, of course, to any historical study of inflation sensitivity of
different asset classes, given that high-inflation periods in the US
from the 1970s onwards have been mostly commodity driven.
ROBUSTNESS OF TACTICAL ASSET SELECTION FOR
INFLATION PROTECTION
There are four main modelling decisions that may affect the empirical results shown in Table 4.1:
1. the six-month investment horizon chosen to measure inflationprotection effectiveness;
2. the definition of high-inflation semesters as those during
which annualised inflation exceeded the samples median;
3. the choice of the S&P GSCI to measure commodity returns;
4. the use of the Ibbotson Associates synthetic US TIPS series.
The choice of six months as the investment horizon was motivated
by the observation that TIPS adjust explicitly to the inflation rate
but pay interest only every six months. A shorter investment horizon can generally be expected to favour those assets whose returns
respond most quickly to unexpected inflation, while a longer investment horizon should favour those assets whose returns most closely
track expected inflation.
Surprisingly, row 1 of Table 4.2 shows that, when the analysis
is conducted using returns in the same month as inflation (that is,
no acceptable delay in asset responsiveness to inflation), the success
rates of the assets included in the comparison differ only slightly: the
best-performing inflation protector remains commodities at 55.4%
followed by stocks at 53.0%, REITs at 51.5%, TIPS at 51.0% and
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Table 4.2 Inflation-protection success rates (%) under different

modelling decisions
REITs Commod. Stocks TIPS Gold
Base scenario (Table 4.1)
1
2
3
4
5
6
7
8
9
65.8
70.4
60.8
53.8 43.2
1 month
51.5
2 months
58.2
12 months
68.9
67th percentile = 4.29
59.4
55.0
65.0
S&P GSCI Energy Index
S&P GSCI Non-Energy Index
Barclays Capital TIPS Index
55.4
61.7
75.5
70.7
66.3
55.0
75.3
61.0
53.0
56.2
71.4
54.9
50.0
55.0
51.0
50.2
56.6
42.9
41.3
27.5
50.0
44.8
46.4
46.6
52.5
60.0
56.3
TIPS Index, S&P 500 Index, S&P GSCI Gold Index, S&P GSCI Energy
Index, S&P GSCI Non-Energy Index.
gold at 50.0%. As row 2 shows, however, the assets differ much

more substantially over two-month periods of relatively high inflation: the most dependable inflation protection has been provided by
commodities (61.7%) followed by equity REITs (58.2%) and stocks
(56.2%), with TIPS (50.2%) lagging slightly. Gold (44.8%) successfully protected purchasing power in fewer than half of high-inflation
two-month periods.
A longer investment horizon should favour assets with stronger
expected returns that are more sensitive to expected inflation. Row 3
of Table 4.2 shows that, during 12-month periods of relatively high
inflation, the most dependable inflation protection was provided
by commodities (75.5%), stocks (71.4%) and equity REITs (68.9%),
with TIPS (56.6%) somewhat weaker; again, gold (46.4%) historically
has covered the inflation rate in fewer than half of high-inflation
12-month periods.
The high-inflation scenarios were defined for Table 4.1 as those
semesters during which inflation exceeded the annualised median
3.2% of the 399 observations in the sample period. As noted, however, inflation during the 1970s and early 1980s reached much
greater severity, up to a maximum of 16.26% during the first six
months of 1980. Rows 46 of Table 4.2 summarise the inflation
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protection provided by each asset class during progressively more

severe inflationary environments: the 67th percentile (corresponding to an annualised inflation rate of 4.3% in our sample), 80th percentile (that is, a 4.9% annualised inflation rate) and 90th percentile
(8.7% annualised inflation). The numbers indicate that commodities and TIPS are progressively less likely to provide returns covering the inflation rate during more severe inflationary periods. Only
gold provides monotonically more dependable inflation protection
during progressively more severe inflationary environments; the
success rates of REITs and stocks change non-monotonically with
respect to the severity of the inflation regime. For those periods
when inflation exceeded its 90th percentile, a condition last experienced during JuneNovember 1981, returns on gold equalled or
exceeded inflation 60.0% of the time, while returns on REITs performed even better, with a 65.0% success rate. It is important to
remember, of course, that the statistical relevance of these results
decreases both with the number of applicable sample points (inflation was higher than the 90th percentile during only 40 semesters
out of the total 399 in our sample) and with the possibility that
a regime change since 1981 may have rendered the older data
obsolete.
Commodity returns were measured using the S&P GSCI, for
which data is available over the full historical period but which is
dominated by energy prices; in contrast, other indexes such as the
Dow JonesUBS commodity index attach significantly less weight
to energy prices but are available over a much shorter historical
period. To investigate the differential contributions of energy and
non-energy commodities, rows 7 and 8 of Table 4.2 summarise the
inflation-protection dependability of the GSCI Energy Index and the
GSCI Non-Energy Commodities Index over the period since February 1983 during which both have been available. The numbers show
that, in the sample considered, energy investments provided much
more dependable inflation protection than non-energy commodities, with returns that equalled or exceeded inflation in 75.3% of highinflation six-month periods compared to just 61.0% for non-energy
commodities.
Finally, US TIPS have been available only since January 1997, so
the performance of TIPS in providing inflation protection cannot
be evaluated using actual returns during the inflationary periods
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of the 1970s and early 1980s. The analysis shown in Table 4.1 used
the synthetic TIPS return series estimated by Ibbotson Associates,
while row 9 of Table 4.2 tests the robustness of the TIPS results by
reporting the inflation-protection dependability computed using an
alternative synthetic TIPS return series estimated by Barclays Capital. As the numbers show, the results are not very sensitive to the
TIPS return series used, with the Barclays Capital synthetic TIPS
Index returns equalling or exceeding inflation in 56.3% of the 199
high-inflation periods in our sample, comparable to the 53.8% computed using the Ibbotson synthetic TIPS Index. The fact that the
two synthetic indexes show similar results does not, of course, rule
out the possibility that both indexes may be affected by common
methodological biases in backfilling historical returns.
USING TACTICAL PORTFOLIO ALLOCATION FOR INFLATION
PROTECTION
Many investors may choose to shift asset class selections tactically
over time, based on their outlook on inflation and other relevant
variables. The asset classes considered display substantial differences in returns during high- versus low-inflation periods, making
this tactical asset selection option both valuable and risky. In other
words, correct insight on future inflation (and its root causes) can
greatly enhance investment returns, while mistakes in forecasting
can prove costly. During the overlapping six-month periods that we
have identified as high-inflation semesters, the average annualised
rate of inflation was 6.1%, compared to 1.8% during low-inflation
semesters.
As Table 4.3 shows, during high-inflation semesters, commodities
provided by far the strongest average annualised returns at 19.2%
per year. This should not be surprising, as commodities not only
account for a substantial share of the CPI but also have been a driver
of short-term inflation spikes13 in the historical window of our study.
Equity REITs and stocks also provided strong returns, averaging
12.3% per year for equity REITs (with income-only returns averaging
8.6%) and 10.2% per year for stocks. The average return on TIPS
barely beat the inflation rate at 6.9%, while gold fell short of the
inflation rate at 6.0%.
How much the ability to discern between high- and low-inflation
regimes affects the outcome is clear by comparing the previous
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Table 4.3 Average annualised returns in high-inflation semesters

Average annualised
return (%)
CPI
Commodities
Equity REITs
Equity REITs (income only)
Stocks
TIPS
Gold
6.1
19.2
12.3
8.6
10.2
6.9
6.0
Table 4.4 Average annualised returns in low-inflation semesters

Average annualised
return (%)
CPI
Equity REITs
Equity REITs (income only)
Stocks
TIPS
Gold
Commodities
1.8
13.7
6.9
13.0
9.2
7.2
2.4
results with the average returns in low-inflation periods (Table 4.4).

During the latter, equity REITs and stocks provided the strongest
annualised returns, averaging 13.7% and 13.0% respectively. (REIT
income-only returns averaged 6.9% per year, far more than the average inflation rate.) The returns on TIPS and gold, too, exceeded the
inflation rate at 9.2% and 7.2% per year, respectively.
By far the worst performing asset class is commodities, with total
returns averaging 2.4% per year during low-inflation regimes:
again, not surprising given the share of commodities in the CPI.
Clearly, the large variance in commodity returns is, in part, the consequence of the high-volatility and self-corrective nature of energy
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price spikes (for example, oil supply shocks), which are virtually
impossible to predict but whose effects tend to average out over
longer investment horizons.
These results (as shown in Table 4.4), if taken at face value, suggest
that, at least in the historical period considered, the winning allocation strategy would have been to shift the portfolio aggressively into
commodities during periods of high inflation, shifting back to assets
that fulfil other investment goals (eg, income, risk-adjusted returns,
diversification), such as equity REITs or TIPS, during periods of low
inflation. Of course, the difficulty with successfully implementing
such a strategy rests in the ability to predict the inflation regime
during the next several months; the consequences of being wrong
are eloquently showcased by the variance in asset class returns that
characterises different inflation regimes.
Although investors typically focus on the risk of high inflation, low inflation (or even deflation) can be equally insidious for
the returns of a portfolio. While insightful asset allocation by the
active investor has the potential to enhance portfolio returns in
either regime considerably, the objective of a strategic asset allocator or hedger is not to select each periods best performing asset
class but, quite to the contrary, to build effective protection against
both inflation and deflation shocks, thus minimising or eliminating
any reliance on the difficult and risky task of correctly forecasting
inflation going forward.
A BALANCED APPROACH TO THE INFLATION-PROTECTED
PORTFOLIO
The fact that various assets respond differently to inflation suggests
that a blended portfolio of assets with differing inflation-protection
properties may provide a better bulwark against inflation than any
asset in isolation. To illustrate this point, Figure 4.2 summarises the
results of a Markowitz (1952, 1959) meanvariance portfolio optimisation exercise conducted using historically realised real returns
(that is, returns in excess of inflation) for the five inflation-sensitive
assets considered during the 199 high-inflation semesters in our data
sample.
Each point in Figure 4.2 shows an optimal asset allocation, from
the minimum-variance portfolio at the left edge (annualised average real return 3.6%, volatility 9.4%, Sharpe ratio14 0.31) to the
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Figure 4.2 Optimal portfolio allocation and success rates in

high-inflation semesters
80
100
US TIPS
78
80
76
70
74
60
Commodities
50
40 S&P 500
30
20
10
0
3.6
72
70
Gold
Success rate (%)
Portfolio asset allocation (%)
90
68
Equity REITs
66
64
4.8 6.1 7.3 8.6 9.8 11.1 12.3 13.6 14.8 16.1
Portfolio expected inflation-adjusted return (%)
Figure 4.3 Optimal portfolio allocation in low-inflation semesters

100
90
80
US TIPS
70
S&P 500
60
50
40
30
Commodities
20
Equity REITs
10
Gold
0
7.7 8.7 9.7 10.6 11.6 12.5 13.5 14.5 15.4 16.4 17.4
maximum-return portfolio at the right edge (annualised average real

return 16.1%, volatility 27.9%, Sharpe ratio 0.55).
The jagged line in Figure 4.2 (right-hand axis) shows the success
rate for each portfolio: that is, the relative frequency with which the
nominal returns on each portfolio equalled or exceeded the inflation
rate during high-inflation semesters in our historical sample. For
example, a portfolio comprising a 55.1% allocation to commodities
with 39.1% invested in equity REITs, 4.6% in TIPS and 1.2% in stocks
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(with no gold) would, over the historical period of our analysis,

have generated nominal returns equalling or exceeding the inflation
rate during 77.9% of the 199 high-inflation semesters, substantially
outpacing the most dependable asset in isolation, commodities, at
just 70.4%.
Maintaining such a maximum-effectiveness (as per our definition) portfolio as a strategic asset allocation, however, would have
exposed the investor to considerable directional risk to inflation. As
Table 4.5 reports, the average annualised real return during highinflation periods was 12.3% over the historical period, with volatility of 18.0% and a Sharpe ratio of 0.65. During low-inflation periods,
however, the portfolio would have generated significantly lower real
returns (8.2% on average) with significantly higher volatility (23.2%),
for a Sharpe ratio of just 0.27.
Over the entire historical period (encompassing both low-inflation and high-inflation periods) the maximum success rate portfolio would have generated real returns averaging 10.2% per year
with 20.9% volatility for a Sharpe ratio of 0.43. The explanation for
this directional risk can be seen by comparing Figure 4.2 with Figure 4.3, which summarises the results of an equivalent Markowitz
meanvariance portfolio optimisation exercise conducted using historical real returns during the 200 low-inflation semesters in our
data sample.
During high-inflation periods (Figure 4.2), the largest roles in
optimised portfolios are played by commodities, TIPS and REITs,
with optimal allocations to TIPS declining as portfolio return and
volatility increase, while optimal allocations to both commodities
and REITs increase. Stocks and gold have very small (and declining) allocations in portfolios optimised over high-inflation historical periods. In contrast, during low-inflation periods the largest
roles in optimised portfolios are played by TIPS, REITs and stocks;
commodities play no role in portfolios optimised over low-inflation
periods except at the lowest levels of portfolio volatility, while
gold accounts for small allocations throughout the riskreturn
spectrum.
In short, portfolios that include substantial allocations to commodities have historically provided dependable protection against
inflation during high-inflation periods, but have exposed investors
to substantial directional risk. In contrast, the historical data suggests
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Table 4.5 Historical performance of optimised investment portfolios
Origination
criterion
Period(s) Ann.
Ann.
Success
of
return volatility Sharpe
rate
inflation
(%)
(%)
ratio
(%)
Maximum
success rate
(high-inflation
periods)1
High
Low
All
12.3
8.2
10.2
18.0
23.2
20.9
0.65
0.27
0.43
77.9
Maximum
Sharpe ratio
(all periods)2
Maximum
Sharpe ratio
(high-inflation
periods)3
High
Low
All
High
Low
All
5.6
9.5
7.5
12.8
8.2
10.5
10.5
12.4
11.7
18.8
24.3
21.9
0.48
0.60
0.54
0.65
0.26
0.42
74.9
Maximum
Sharpe ratio
(low-inflation
periods)4
Minimum
variance
(all periods)5
High
Low
All
2.4
9.0
5.7
9.8
8.9
9.9
0.19
0.79
0.45
57.8
High
Low
All
High
Low
All
3.1
7.6
5.3
3.6
8.3
5.9
9.6
8.3
9.3
9.4
9.0
9.5
0.25
0.67
0.44
0.31
0.70
0.49
67.3
High
Low
All
2.0
7.7
4.9
10.0
8.1
9.5
0.14
0.71
0.38
59.8
Equal Sharpe
High
ratios in
Low
high- and lowAll
inflation periods8
6.0
8.3
7.1
10.4
12.0
11.3
0.52
0.52
0.52
75.4
Minimum
variance
(high-inflation
periods)6
Minimum
variance
(low-inflation
periods)7
75.9
69.3
1 Allocation:
55.1% commodities, 39.1% REITs, 4.6% TIPS, 1.2% equities, 3.3% gold. 2 Allocation: 48.9% TIPS, 16.9% REITs, 14.6% commodities, 13.9% equities, 5.8% gold. 3 Allocation: 58.1% commodities, 41.3%
REITs, 0.5% equities, 0% gold. 4 Allocation: 78.7% TIPS, 10.8% equities,
5.4% gold, 5.0% REITs, 0% commodities. 5 Allocation: 80.9% TIPS, 8.4%
commodities, 5.8% gold, 4.9%, 0% REITs. 6 Allocation: 73.3% TIPS, 8.6%
commodities, 8.4% equities, 5.0% gold, 4.8% REITs. 7 Allocation: 90.4%
TIPS, 5.3% gold, 2.6% commodities, 1.7% equities, 0% REITs. 8 Allocation:
54.1% TIPS, 21.8% commodities, 14.5% REITs, 6.4% equities, 3.3% gold.
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Figure 4.4 Optimal portfolio allocation: all semesters
100
90
80
US TIPS
S&P 500
70
60
50
Commodities
40
30
20
Gold
Equity REITs
10
0
5.3
6.1 6.8 7.6 8.4 9.1 9.9 10.6 11.4 12.1 12.9
that TIPS and equity REITs play important roles in optimised

portfolios during both low- and high-inflation periods.
Indeed, as Figure 4.4 shows, TIPS and REITs together account for
half or more of the optimised investment portfolio over nearly every
part of the riskreturn spectrum in a Markowitz meanvariance
optimisation conducted using real returns for the entire historical
period included in the analysis, with TIPS especially important in
low-volatility portfolios and REITs playing the dominant role in
high-return portfolios.
For investors seeking to reduce directional risk associated with the
realised inflation rate, an alternative to the effectiveness-maximising
investment strategy presented earlier, under which directional risk is
considerable, might be to select the strategic asset allocation that generated the strongest risk-adjusted returns over the entire historical
period.
Table 4.5 identifies this portfolio as being composed of 48.9%
TIPS, 16.9% equity REITs, 14.6% commodities, 13.9% stocks and
5.8% gold: this portfolio generated historical real returns averaging 7.5% per year, with an 11.7% volatility and a Sharpe ratio of 0.54.
Moreover, this portfolio was quite successful in protecting against
inflation, providing nominal returns that equalled or exceeded the
inflation rate in 74.9% of high-inflation six-month periods. While this
portfolio is not as effective as the maximum success rate portfolio
(77.9%), its effectiveness is superior to the best asset in isolation, ie,
commodities at 70.4%.
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Investors using the maximum Sharpe ratio asset strategic allocation, however, would still have been exposed to directional risk
related to the inflation rate (Table 4.5). During low-inflation periods, this strategic asset allocation would have generated real returns
averaging 9.5% per year, with volatility of 12.4% and a Sharpe
ratio of 0.60. During high-inflation periods, however, the maximum
Sharpe ratio allocation would have produced substantially lower
annualised average real returns (5.6%), with only moderately lower
volatility (10.5%) and a Sharpe ratio of 0.48.
Investors seeking to eliminate directional risk altogether (at least
on an expected basis) could have instead chosen a portfolio comprising a 54.1% allocation to TIPS along with 21.8% in commodities,
14.5% in equity REITs, 6.4% in stocks and 3.3% in gold. Across the
entire historical period, this portfolio would have generated real
returns averaging 7.1% per year with 11.3% volatility, for a strong
Sharpe ratio of 0.52; the portfolio would also have provided very
dependable protection against inflation, with nominal returns covering the inflation rate in 75.4% of high-inflation periods. Moreover, the
risk-adjusted returns of this portfolio would not have depended on
the inflation rate: during high-inflation periods real returns would
have averaged 6.0% with 10.4% volatility (Table 4.5), while during
low-inflation periods both real returns (8.3%) and volatility (12.0%)
would have been commensurately higher, resulting in no difference
in returns on a risk-adjusted basis (ie, Sharpe ratios).
INFLATION SENSITIVITY OF DIFFERENT PROPERTY TYPES

The value of income-producing real estate in protecting against inflation arises from the adjustment process by which lease rents respond
to changes in inflation. Different types of property, however, are characterised by significant differences in lease provisions, and these give
rise to differences in their inflation sensitivity.
Perhaps the most important provisions for inflation sensitivity are
the lease term and, consequently, the frequency of lease turnover
and negotiation. At one extreme, hotels have typical lease terms of
only one night, or a few nights, implying that rents can be adjusted
almost continuously in response to changes in inflation, as well as
other factors. Rental apartments typically employ 12-month leases,
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Table 4.6 Inflation protection success rates by property type

Success ratio (%)
Self-storage
Residential
Shopping centres
Equity REITs
Industrial
Office
Regional malls
Lodging
Health care
Free-standing retail
Commodities
TIPS
Equities
81.0
77.8
73.0
71.4
71.4
69.8
69.8
68.3
68.3
61.9
81.0
63.5
58.7
perhaps with monthly lease extensions after the first year, implying that rents can be adjusted annually, if not monthly; self-storage
facilities typically have similarly short lease terms.
For hotel, apartment and self-storage properties, the fact that lease
rents are typically fixed during the entire duration of the contract
term is mitigated by the fact that contract terms are typically short,
potentially enabling property owners to adjust rents in response to
inflation. Other property types may employ automatic adjustments
to changes in inflation, whether explicit or implicit. For example,
many retail leases specify monthly rental payments as a function of
the sale revenues generated by each store; thus, as inflation affects
the sale prices of consumer goods, it affects lease rents as well.
In some cases, especially with tenants that are government agencies, office leases may include an explicit adjustment in response to
inflation; in these cases, office property returns may be sensitive to
inflation even with long lease terms. A slightly different mechanism
may affect lease rents for health-care properties, including long-term
care facilities: if health-care reimbursement rates are regulated, then
inflation may be accounted for in determining payments for various health-care services, and therefore pass through to owners of
health-care properties.
Table 4.6 presents the same analysis of the inflation-protection
effectiveness shown in Table 4.1, but focuses on publicly traded
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equity REITs across different sectors over the historical period from
January 1994 to August 2011 for which data is available.15 As
Table 4.6 shows, the two property sectors that provided the most
effective inflation protection, with returns greater than or equal to
inflation during high-inflation semesters, were self-storage (81.0%)
and residential (77.8%), that is, two of the property types characterised by short lease terms, and therefore frequent lease turnover
and renegotiation. Lodging, however (the third property type characterised by short leases), demonstrated a success rate of just 68.3%,
less than the equity REIT industry as a whole (71.4%). Shopping
centres, too, provided inflation-protection dependability above that
of the industry as a whole, at 73.0%, but the other two retail property types, regional malls (69.8%) and especially free-standing retail
(61.9%), fell short of the industry average, as did other property
types including office (69.8%) and health care (68.3%).16
INFLATION HEDGING WITH ILLIQUID REAL ESTATE
INVESTMENTS
We have measured real estate investment returns using the returns
on publicly traded equity REITs, but several other real estate
indexes are available, including the NCREIF Property Index (NPI) of
unleveraged core property returns published by the National Council of Real Estate Investment Fiduciaries, the Open-End Diversified
Core Equity (ODCE) Fund Index, also published by NCREIF, and
indexes of private equity real estate fund investments published
jointly by NCREIF and The Townsend Group.17 All of these indexes
measure the returns of illiquid investments, either in commercial
properties themselves (held directly or through separate accounts
with investment managers) or in non-traded shares of private equity
real estate funds.
The illiquidity of such real estate investments means that their
periodic returns, unlike the returns of publicly traded REIT equities,
cannot be measured directly on the basis of price discovery from
actual transactions.18 Instead, returns on unlisted real estate investments are appraisal based, ie, appraisals are conducted (whether
internally or externally) and used to periodically (typically quarterly) estimate the capital appreciation component of total returns.
For the purpose of evaluating non-traded real estate holdings as an
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Table 4.7 Correlations of private real estate return measures with

inflation
Return component
Measure
Correlation with
quarterly CPI (%)
Capital appreciation
NPI
ODCE
31
31
Income return
NPI
ODCE
17
27
Total return
NPI
ODCE
TBI
32
33
10
Source: NCREIF Property Index, Open-End Diversified Core Equity Fund

Index, Transaction Based Index.
inflation hedge, this introduces a critical problem, as current or estimated inflation is a typical input in the appraisal process, or in the
extrapolation between appraisals. Thus, comparing appraisal-based
returns with inflation as a means of analysing sensitivity to inflation
becomes tautological.19
Circumstantial evidence for this problem can be seen in Table 4.7,
which shows the correlation between quarterly inflation and quarterly capital appreciation and income returns on illiquid real estate,
as measured by the NPI and the ODCE. For both indexes, correlation between capital appreciation and inflation (31%) is greater than
correlation between income and inflation (27% from the ODCE, and
just 17% from the NPI). This suggests that the appraisal-based values of commercial properties fluctuate more strongly in response
to inflation than does the quarterly income produced by the same
properties (as measured by actual rents received).
Additional evidence is uncovered by comparing correlations
computed from appraisal-based total returns with correlations computed from actual transaction values. Table 4.5 also shows the correlations of quarterly inflation with quarterly total returns measured
by the NPI, the ODCE and the Transaction Based Index (TBI) calculated until recently by the Center for Real Estate at the Massachusetts Institute of Technology. The TBI is computed using all the
transactions of properties that are also in the database used to compute the NPI, which itself has substantial overlap with the database
used to compute the ODCE, implying that differences among the
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assets underlying the three indexes are slight. The computed correlations, however, are different: just 9.8% using actual transaction
values as measured by the TBI, compared with 32% using appraised
values from the NPI, and 33% using appraised values from the
ODCE.
To summarise, we caution against the use of appraisal-based estimates to evaluate the sensitivity of asset returns to inflation. While
the evidence reviewed here is specific to the real estate asset class
in the US, the conclusion seems equally applicable to other illiquid assets whose values and returns are estimated by appraisal. If
valuations are influenced in part by the appraisers awareness of
current or expected inflation, then evaluating inflation sensitivity
may amount to tautology.
CONCLUSIONS
According to the Gordon growth model, real estate can be considered
a perfect hedge against inflation, under the strong assumption that
future rent growth and discount rates move in line with expected
and actual inflation rates. In this chapter, we have examined the
historical performance of real estate as an inflation hedge from 1978
to 2011, and compared it with other inflation-sensitive asset classes.
In the historical sample, looking at single asset classes first, commodities provide the best inflation protection, as per the measure
of hedge effectiveness adopted here, with an overall success rate of
70% in high-inflation semesters (75% for energy commodities and
61% for non-energy commodities). These results are only slightly
sensitive to differences in the time horizon used to calculate returns,
the demarcation line used to define high-inflation periods and the
choice of synthetic TIPS return series.
During low-inflation periods, however, commodities generated
the lowest returns of any asset class considered. This large performance difference highlights the utility of constructing a balanced
portfolio if performance in both high- and low-inflation regimes is
the goal.
Historically, a Markowitz meanvariance optimisation suggests
that a blended portfolio, invested 49% in TIPS, 17% in equity REITs,
15% in commodities, 14% in stocks and 6% in gold, achieves the
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maximum Sharpe ratio (0.54) across all semesters in our sample. The
success rate of this multi-asset-class portfolio is quite high (75%), but
it also has considerable directional risk.
To mitigate the latter, historically, slightly more could have been
invested in TIPS (54%) and commodities (22%), and slightly less
in equity REITs (14%), stocks (6%), and gold (3%). Historically, this
portfolio has provided not only a similar success rate (75%) in highinflation semesters, but also a similar Sharpe ratio (0.52), with the
advantage that the latter is identical in both high- and low-inflation
periods.
Finally, investors seeking to maximise the success rate in highinflation semesters, without regard to directional risk, would have
chosen a more aggressive portfolio, with 55% in commodities, 39%
in REITs, 5% in TIPS, 1% in stocks and no gold holdings. Historically,
this portfolio has a success rate of 78% in high-inflation semesters,
but considerable directional risk.
Different property types provide different levels of inflation protection, depending on the extent to which rents adjust to inflation. The property types expected to provide the strongest inflation
protection are those characterised by short-duration leases, or by
rents linked to revenues. Empirical data generally supports these
expectations, with self-storage, residential properties and shopping
centres having a success rate ranging from around 75% to 80%
in high-inflation semesters (Table 4.6), higher than the industry
average (71%).
Although we have used publicly traded equity REIT returns, similar empirical analysis could in principle be conducted using returns
on illiquid investments, ie, properties themselves or private equity
real estate investment funds. Unfortunately, the latter are typically
estimated by appraisals, which are linked to inflation, thus making
an analysis of their price sensitivity to inflation amount to tautology.
The empirical evidence examined in this chapter suggests that a
variety of assets have inflation-protecting characteristics. Real estate,
considered a strong inflation hedge on conceptual grounds, has in
fact performed as well as, or better than, other inflation-sensitive
assets in the historical sample considered, and has not exposed
investors to significant directional inflation risk. Indeed, based
on both empirical results and theoretical arguments, real estate,
accessed through publicly traded equity REITs, provides attractive
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return characteristics and deserves consideration in diversified

inflation-protected portfolios.
Dr Susan Wachter acknowledges assistance from the Research
Sponsors Program of the Zell/Lurie Real Estate Center at Wharton.
Strategic asset allocation is the choice of a set of portfolio weights that are not expected to
change in response to market conditions, requiring only that the portfolio be rebalanced periodically to the strategic weights. Tactical asset allocation is the choice of portfolio weights in
response to current market conditions, overweighting assets or asset classes that are expected
to outperform, while underweighting those expected to underperform.
Discussing the limitations of this simple valuation model is outside the scope of this chapter.
For a discussion with reference specifically to real estate and REITs, see Geltner et al (2007).
Clearly, this is a very strong assumption that may not generally hold in reality, but it is a
useful baseline for illustrating the relevant issues.
Demand shocks also affect real interest rates in the short run.
See http://www.snl.com.
If the analysis is restricted to the historical period from January 1990 to September 2008,
thereby excluding the liquidity crisis of 20089, then during months of higher-than-median
inflation the median return of high-leverage REITs (1.14%) is slightly less than the median
return of low-leverage REITs (1.17%); during months of lower-than-median inflation, returns
to high-leverage REITs were more markedly less than returns of low-leverage REITs (1.34%
versus 1.92%).
That is, month n principal is linked to an interpolated value of the CPI published in months
n 1 and n 2, which measure inflation in months n 2 and n 3, respectively. Moreover,
TIPS income is paid only every six months, a consideration relevant to some retail investors.
For example, we might define the most effective hedge as the one that minimises the variance
of the overall position. In this case, if series Y and X have correlation and volatilities Y
and X , respectively, the optimal hedge ratio is given by h = X /Y , which means that to
obtain the optimal (minimum variance) hedge we need to sell h units of asset Y for each unit
of X.
Note that the observations are not statistically independent.
10 January 1978 is the first date for which the S&P GSCI Gold Index is available. Data for the
other assets is available from January 1972 (the starting date of the FTSE NAREIT Equity
REITs Index); over the longer historical period the success rate was about 67% for both REITs
and commodities, and about 55% for both stocks and TIPS.
11 Although TIPS income return is linked to, and thus increases with, inflation, the TIPS Index
also has real rate duration, ie, its price decreases with an increase in real rates. This effect
is especially important before TIPS first issuance, where real rates have no observable market dynamics, and are reconstructed by subtracting realised inflation to market-observable
nominal rates. Since nominal rates typically increase more than one-to-one with inflation,
these historically backfilled synthetic real rates will also tend to increase with inflation and
decrease with index price, thus underestimating the hedging performance of the asset class
in high-inflation scenarios.
12 This ranking may seem intuitive given that higher-volatility, higher-return assets such as
commodities, REITs and equities will have a greater chance to satisfy our inflation-protection
criterion during high-inflation periods. As noted in the next section, however, this intuition
does not hold firmly. The reader should bear in mind that the measured performance of TIPS
may be sensitive to the methodology used to construct a synthetic TIPS return index for
periods preceding TIPS issuance (ie, before 1997), as discussed in the next section.
13 This is mirrored by the fact that commodities become the worst performing asset in lowinflation months.
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14 The Sharpe ratio is defined as the ratio of portfolio return in excess of the risk-free rate to
portfolio volatility. In the analysis, the monthly risk-free rate is given by the return on the
Citigroup BIG 1-month US Treasury Bill Index.
15 The historical period for the analysis of inflation-protection dependability by property type
begins in January 1994, the inception date for the FTSE NAREIT family of property-type
indexes.
16 Other property types for which separate historical data is not available include timberland
and specialised data centres.
17 See http://www.ncreif.org.
18 Transaction-based indexes of commercial property values and returns do exist, including the
TBI employed later in this section. Several researchers, including Lin and Vandell (2007),
Cheng et al (2010) and Bond and Slezak (2010), however, have noted that transaction-based
index methodologies applied to illiquid assets provide biased measurements of both the
average and the volatility of returns or changes in value.
19 The same, or an analogous, problem may affect the backfilling of returns on TIPS prior to
December 1997.
REFERENCES
Bhardwaj, G., D. J. Hamilton and J. Ameriks, 2011, Hedging Inflation: The Role of
Expectations, Report ICRUIHE 042011, Vanguard Group, URL: https://www.vanguard
investments.de/content/documents/Articles/Insights/hedging-inflation.pdf.
Bond S. A., and S. L. Slezak, 2010, The Optimal Portfolio Weight for Real Estate
with Liquidity Risk and Uncertainty Aversion, Working Paper, URL: http://ssrn.com/
abstract=1691503.
Cheng, P., Z. Lin and Y. Liu, 2010, Illiquidity and Portfolio Risk of Thinly Traded Assets,
Journal of Portfolio Management 36(2), pp. 12638.
Geltner, D. M., N. G. Miller, J. Clayton and P. Eichholtz, 2007, Commercial Real Estate:
Analysis and Investments, Second Edition (Mason, OH: Thomson South-Western).
Gordon, M. J., 1962, The Investment, Financing and Valuation of the Corporation (Homewood,
IL: Irwin).
Lin, Z., and K. Vandell, 2007, Illiquidity and Pricing Biases in the Real Estate Market,
Real Estate Economics 35(3), pp. 291330.
Lomelino, D., K. Gillett and M. Komarynsky, 2011, Inflation Hedging with InflationLinked Bonds, Report, Towers Watson, URL: http://www.towerswatson.com/assets/
pdf/4125/1101-TIPS-FIN.pdf.
Markowitz, H., 1952, Portfolio Selection, The Journal of Finance 7(1), pp. 7791.
Markowitz, H., 1959, Portfolio Selection: Efficient Diversification of Investments (New York:
John Wiley and Sons).
Ralls, B., 2010, Inflation or Deflation: Prepare for Either, Fidelity Investments, URL:
https://guidance.fidelity.com/viewpoints/inflation-vs-deflation.
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Infrastructure Assets and Inflation
Gerald Stack, Dennis Eagar, Kris Webster

Magellan Group
The aim of this chapter is to define the infrastructure asset class,

and to explain how each different segment within the infrastructure
class is linked to inflation. In fact, for infrastructure to be considered
a separate asset class, it must generate returns that are different from
other asset classes. Indeed, infrastructure provides a unique and distinct investment opportunity, as companies often operate in a quasimonopolistic environment where demand is fairly price inelastic.
Because of this, and because their earnings are structurally linked to
inflation, infrastructure companies can generate remarkably stable
real (ie, inflation-adjusted) returns over the business cycle.
INFRASTRUCTURE DEFINED
The term infrastructure can be used to express a multitude of meanings. For the purposes of this chapter, an asset is taken to be an
infrastructure asset if
it provides a service that is essential for the efficient functioning
of a community, and hence faces reliable demand irrespective

of underlying economic conditions,
the cashflows it generates are not affected by external variables,
such as competition, technology obsolescence or commodity

price risk,1
the earnings generated by the asset are structurally linked
to inflation (for assets that meet this definition, the financial

returns will be robust across economic cycles and protected
from inflation).
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The primary sectors falling within our definition of infrastructure

are energy and water utilities, tollroads and airports. Each of these
sectors exhibits different investment characteristics, and is affected
differently by inflation.
Clearly, there are a number of assets commonly referred to as
infrastructure that fail the definition outlined above. For example,
merchant power generators (ie, power generators that sell their output at prevailing market rates) provide an essential service, but the
price they receive for the power they generate fluctuates over time.
In fact, since their output is relatively constant, demand and prices
will fluctuate along with the prevailing economic conditions. As a
result, their cashflows are neither stable nor structurally linked to
inflation, and consequently they are not considered infrastructure
for our purposes.
THE IMPACT OF INFLATION ON INFRASTRUCTURE ASSETS

A sustained increase in inflation has several effects on a typical company. First, input costs will generally increase; in addition, higher
interest rates will increase borrowing costs,2 as well as reduce the
discounted net present value of future revenues generated by the
company. In such a scenario, companies can be expected to respond
by raising prices. However, to the extent that a company is unable to
pass through increases in input or borrowing costs without affecting demand or market share, inflation will negatively affect earnings
and, consequently, returns to shareholders. The size of the impact
will be determined by the companys pricing power, competitive
position and debt structure, as well as the price elasticity of demand
for its products and services. In practice, very few companies operating in competitive markets will not suffer some diminution in value
if inflation increases.
While the average company struggles to deal with the effects
of inflation, the impacts upon infrastructure assets are relatively
benign, and can even be positive for earnings and underlying value.3
The ability of infrastructure assets to mitigate the effects of inflation hinges on the highly inelastic demand for their services, which
enables infrastructure assets to pass on an increase in inflation with
limited, if any, impact on underlying demand.
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INFRASTRUCTURE ASSETS AND INFLATION
As mentioned above, there are three separate segments that fit our
definition of infrastructure assets. We will discuss each of these, and
their unique features, in the following.
ENERGY AND WATER UTILITIES
Utilities that meet our previously stated definition of infrastructure
include the following:
utilities that engage in transmission and distribution4 of elec-
tricity; these companies are responsible for either the transport of electricity from power generators to communities on
high-voltage power lines or for electricity distribution within
communities on low-voltage power lines;
utilities that engage in the transmission and distribution of gas;
these entities use pipelines to transport gas from natural gas

basins to the ultimate end-users, such as households;
utilities that supply water and/or treat waste water.
Because of the vital public and safety service provided, these companies have a natural monopoly and are generally heavily regulated,
with the government monitoring and controlling the price charged
for their services. In essence, the relevant government regulator
grants the privilege (and responsibility) to deliver reliable, quality
service and, in exchange, it sets a pricing mechanism to secure a fair
rate of return for the utility company.
The price-setting process requires the regulator to take into
account the impact of several effects, including higher interest rates
(which, as mentioned before, affect the cost of debt and equity capital) and higher inflation (which increases operating costs and construction costs on new assets built, as well as the value of the assets
already owned). As a consequence, the value of an efficiently regulated utility company, as measured by the net present value of
its cashflows, should be relatively stable, irrespective of economic
conditions, and inflation in particular.5
In practice, the protection to earnings from inflation depends upon
the frequency of the price-setting process, which usually includes a
period of public consultation, and therefore an often sizeable regulatory time lag. Although the latter varies according to different
jurisdictions, price reviews are generally conducted annually, at the
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Table 5.1 Pricedemand inelasticity on the Eastern Distributor tollroad,

Australia
Date of
increase
July 2001
April 2003
October 2004
March 2008
September 2010
Toll
increase (%)
17.0
14.0
13.0
8.6
8.6
Traffic growth (%)

Quarter
Year
+9.2
+5.8
+5.5
+2.5
+2.3
+15.6
+5.0
+4.8
+0.4
+2.5
Source: Magellan Asset Management, Transurban Group.
request of either the utility company or community groups. Thus,

the utility company is afforded a high level of protection from the
effects of inflation.
TOLLROADS
Around the world, the standard business model for a tollroad is
that a government agency enters into a concession agreement that
entitles the tollroad company to collect tolls for a defined period,
and increase those tolls on a regular basis,6 in a contractually defined
way. At the end of the concession, the road needs to be handed back
to the government, in a good state of repair.
In most markets, the tollroad is not the only road route available
to motorists (water crossings like bridges being an exception). Consequently, the tollroad is not a pure monopoly. However, some of the
reasons why it is built in the first place might be because the alternative routes are not suitable for high-speed or long-distance travel,7 or
are highly congested and operating at, or close to, capacity. The opening of a new tollroad inevitably reduces traffic on the alternative tollfree routes, at least in the short run. Over time, however, any growth
in traffic will plausibly increase flow in the free roads first, until the
latter are soon again operating at capacity, after which the tollroad
will effectively behave much like a monopoly, with the company in
charge benefiting from considerable price-setting power (although
the government usually monitors and controls the price-setting process, through terms specified in the concession agreement). As an
example, Table 5.1 shows our analysis of the impact of toll increases
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Table 5.2 Tollroad price concession agreements
Asset
Location
Basis of
toll increases
407 ETR
Canada
APRR
Atlantia
Brisa
Chicago Skyway
France
Italy
Portugal
US
CityLink
Australia
Greater of
4.5% or CPI
to 2015 then
CPI
Quarterly
Eastern Distributor
Australia
Greater of
4.1% or
basket of 67%
average
weekly
earnings and
33% CPI
In A$0.50
increments
US
Greater of
2%, CPI or
nominal GDP
per capita
CPI
At operators
discretion
Annually
Indiana Toll Road
M5
M6 Toll
Western Harbor
Tunnel
Australia
UK
Hong Kong
At operators
discretion
85% of CPI
70% of CPI
90% of CPI
Greater of
2%, CPI or
nominal GDP
per capita
Frequency
CPI
Discretionary
Annually
Annually
Annually
Annually
Annually
Discretionary
Annually
CPI denotes Consumer Price Inflation, as measured by the index specified

in the contract. GDP denotes Gross Domestic Product. The formula is
applied to a theoretical toll each quarter, but tolls only increase when
rounding takes it to the next A$0.50 increment.
Source: Magellan Asset Management, underlying operators.
on demand for the Eastern Distributor, a tollroad located in Sydney,

Australia, over the first decade of the 21st century. As can be seen,
demand has been very price inelastic, as traffic has kept increasing
despite higher tolls.
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As mentioned above, the basis on which tolls are increased is controlled by the terms of the concession agreement. There are only
three toll roads of any significance in the Western world where the
concessionaire has full discretion on toll increases: the M6 Toll in
the UK, the 407 ETR in Canada and the South Bay Expressway in
California. All other tollroad operators have to follow specific formulas, which are generally linked to inflation. Table 5.2 provides
an illustrative cross-section. As can be seen, the pricing mechanism
for these tollroads picks up any increases in inflation, with minimal
lag. Consequently, the majority of tollroad operators have the ability to respond quickly to any spike in inflation. And as the data in
Table 5.1 highlights, tollroad concessionaires can expect that there
will be minimal, if any, disruption in demand as tolls are increased,
so revenues, which are the product of toll price and traffic volume,
will fully offset the inflationary impact.
Of course, the other key area where inflation can have an impact
is on capital expenditures. With most tollroads, however, capital
expenditures are minimal, and generally limited to keeping the
roads in good operating conditions, by resurfacing, replacing ageing
crash barriers, etc, as needed. Consequently, for this infrastructure
segment, inflation has very little material effect when it comes to
capital expenditures. Another crucial aspect is that tollroads, like
most infrastructure assets, are generally more highly leveraged than
average industrial companies. The impact of higher inflation on debt
costs is important, and it is covered later in the chapter.
AIRPORTS
Airports involve two separate businesses, ie, airside and landside
operations.
Airside operations encompass the management of the aeronautical aspects, such as the operation and maintenance of the runways
and taxiways of the airport. The majority of airside revenue is generated by a charge levied on passenger movements (ie, passenger
arrivals and/or departures), a charge levied on each aircraft movement or a combination of both. In most jurisdictions, the onus is on
the airport to negotiate appropriate charges with the airlines, with
some form of regulation as a fall-back position. This component
of the airports operations therefore behaves much like a regulated
utility, with increases in inflation leading to increases in charges in
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order to ensure the airport earns a fair rate of return on the capital
invested.
Landside operations involve the remainder of the airport, and fall
into three primary areas: retail operations, car parking and general
property development. Most airports do not directly run the retail
outlets. Instead, they act as the lessor and receive a guaranteed minimal rental, normally indexed to inflation, along with a share of sales.
Hence, a spike in inflation will lead to an increase in nominal retail
sales (assuming static demand), and the airport will benefit from the
inflation protection of these revenues.
The car parking operations at the airport generally behave like a
monopoly, although there is some substitution threat, ie, the potential for travellers to park off airport, or to use alternatives, such as
taxis or public transportation. However, the level of substitution
threat is generally weak, and thus the airport has significant pricing
power that can be used to offset inflationary spikes.
As for property development, there is a range of businesses that
seek to be located on or close to airports, including the airlines
and freight forwarders, along with the customs and immigration
officials. Accordingly, airport operators typically invest in property
assets and act as the lessor, receiving a rental stream that is indexed
to inflation, thus offering protection against rises in price levels.
Airports incur the highest level of capital expenditures among
the infrastructure segments. Airside capital expenditures include
widening and extension of runways and taxiways, and are generally undertaken after consultation and agreement with the airlines
as well as the relevant regulatory authorities. Airside charges are
typically increased to recover these development and maintenance
costs over time. Landside capital expenditures are often incurred
to increase the retail or parking space available, or other property
leasing facilities. Higher inflation may affect the financial viability of
such capital expenditure, but it is expected that the airport operator
will be rational and elect not to proceed with such expansion projects
if the project is not expected to yield a reasonable real rate of return.
In other words, if project and revenue planning is done correctly,
inflation will increase the cost of capital expenditures and yet have
a minimal impact on the value of the airport asset as a whole.
When considering an airport asset as an investment, there are several issues that need to be carefully considered, as they contribute
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to the operational efficiency of the infrastructure asset. For example,

airports in certain countries might find it more challenging to manage the cost base of their workforce because of existing labour laws,
thus making the infrastructure asset more vulnerable to inflation
spikes, all other things being equal.8
IMPLICATIONS OF HIGH LEVERAGE ON INFRASTRUCTURE
ASSETS
Due to the relatively robust long-term revenues produced by infrastructure assets, many companies are able to obtain relatively cheap
long-term debt, by comparison with the average industrial company.
And because leverage levels are generally high by industrial company standards (the capital structure of a typical regulated utility
comprises approximately 5060% debt, and the remaining 4050%
equity), the structure of debt is of significant importance to infrastructure companies, and generally very carefully managed, both
in terms of cashflows and overall value. In fact, during the turmoil in the global credit markets experienced in 2008 and 2009, very
few infrastructure companies experienced problems in meeting their
pre-existing debt obligations, or even funding new debt. This was in
distinct contrast to other highly leveraged businesses, such as banks
and real estate investment trusts.
As discussed before, utilities have the ability to recover the cost
increases related to an inflationary spike through a periodically regulated price-adjustment mechanism. The latter generally includes
specific allowance for an increase in financing costs, and thus exposure to interest rates will be limited to the length of time between
reset periods, and the regulatory time lag. Provided the utility
company hedges its residual interest exposure due to these frequency/lag effects, cashflow management is pretty straightforward,
and the net present value of earnings should be fairly insensitive to
movements in interest rates.
Airports and tollroads do not enjoy the automatic linkages to
increased borrowing costs that utilities do and, while their revenue streams enjoy inflation linkages, there are few mechanisms
to recover increased borrowing costs. Because of this, most companies swap their floating-rate debt into fixed-rate debt; by doing
so, they usually incur an interest rate term risk premium, but they
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simplify their cash-management position, as they will be able to service their debt with stable fixed-rate outflows, even if interest rates
rise. In addition, the net-present value of their long-term fixed-rate
liabilities will decrease if interest rates and inflation increase, thus
offsetting, at least in part, the imperfect inflation-linkages on the
revenue side.
CONCLUSIONS
Although infrastructure is a relatively new asset class for many
investors, it is increasingly seen as an attractive substitution alternative in the context of a diversified portfolio. When it comes to
inflation protection in particular, several characteristics provide an
attractive platform for investors seeking a safe haven, including
the fact that infrastructure revenues are typically structurally linked
to inflation and relatively high levels of debt are generally managed
prudently in order to minimise, or even benefit from, interest rate
movements.
1
Although commodity price risk is definitely a cause of earnings volatility, the link between
commodity prices and inflation is weak at best. This is why, in the example that follows, we
do not consider merchant power generators to be infrastructure assets, as their earnings are
business cyclical, and yet not structurally linked to inflation.
Here we assume the debt is floating rate and resets periodically. Note that, in this case, if
inflation and interest rates rise, the cashflow outlays required to service the debt will increase,
but the debts net present value will remain unchanged.
This depends on the price-transferring mechanisms, the structure of operating costs and the
nature of liabilities.
Transmission refers to the transport of the commodity from source to the distribution hub, eg,
from the electricity generation plant to an electricity sub-station in a community. Distribution
is the transport of the commodity from the distribution hub to the point of use, ie, homes,
offices, factories, etc.
In other words, for the value of an infrastructure asset to be stable, earnings should grow with
inflation, so that their net present value remains unchanged.
Toll increases usually occur in sizeable increments and in a highly publicised manner for the
Eastern Distributor (Table 5.1), as tolls are paid in cash. Fully electronic tollroads, like the
CityLink in Melbourne (Australia), the Westlink M7 in Sydney (Australia) and the 407 ETR
in Toronto (Canada) have tolls regularly increased by lower increments, with little fanfare,
and no impact on demand.
This is the case for many European highways.
This is true for several airports in Europe, while the issue is typically not present in Australia
and New Zealand.
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Equity Investments and Inflation
Steven Bregman, Murray Stahl

Horizon Kinetics LLC
Unlike a stock market crash, inflation erodes wealth insidiously and

covertly. Given the unprecedented amount of stimulus provided by
the US Government between 2008 and 2011, the utmost vigilance
is required to protect the real value of assets from the effects of
inflation. In this chapter we shall discuss some investment strategies that can help to achieve this objective. Traditional methods of
acquiring inflation protection, such as purchasing physical gold or
other commodities, might not be the most effective, as better and
less speculative alternatives exist. In particular, there are business
models, and thus equity securities, which benefit during periods of
inflation yet do not necessarily depend upon inflation in order to
prosper. In addition, under certain conditions, some fixed-income
securities, such as convertibles, can also offer inflation protection. In
this chapter we shall cover such equity strategies and examine their
more salient characteristics.
INFLATION AND EQUITY PRICES
The complexities of inflation and how certain equity investments
might mitigate its effects are not always as obvious as they may
seem. It can be most challenging to discern the diverse ways in
which inflation affects different assets, as well as the reactions of
market participants, and thus the impact on prices. While equity
prices are generally thought to incorporate an inflationary component, as both output and input prices incurred by businesses are
directly affected, the process of exploiting this relationship can often
prove counterintuitive.
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Table 6.1 Carmike Cinemas, Inc: price changes versus consumer price
inflation (19922010)
Average price per patron

Year
Admission
(US$)
Concessions
(US$)
Total
(US$)
1992
2010
3.47
6.85
1.28
3.43
4.75
10.28
Annualised price change (%)

CPI annualised change (%)
3.9
5.6
4.4
2.5
CPI, All Urban Consumers, US City Average (all items); not seasonally
adjusted.
Source: data from Department of Labor, Bureau of Labor Statistics.
We shall illustrate this point by using Carmike Inc as the business model typical of cinema chains (Table 6.1).1 Historically, cinemas have had sufficient pricing power to raise ticket and concession
prices at rates exceeding general inflation price indexes. This pricing power has persisted even though this particular business sector
experienced some degree of saturation during the period considered, when the market might have been expected to revert to a pricecompetitive system (cinema attendance in North America peaked in
2002).
Even modest pricing power (Table 6.2) is important, as it can
be leveraged against a relatively fixed cost structure, resulting in
a meaningfully greater expansion in net income (which, simply put,
means that if most of your costs are fixed, but you can increase your
prices, then net income (revenue minus costs) will increase). A cinema chain is a good example of a high-fixed-cost, low-marginal-cost
business. Some 85% of the operating expenses of a cinema are relatively fixed: basic operating expenses such as rent and film exhibition
costs. Costs that might be considered more variable with respect to
patronage volumes, administrative expense and the cost of operating the food concessions amount to only about 3% each. Revenues
from the food concessions, though, comprise about one-third of revenues, the balance being ticket sales. Accordingly, the change in operating costs between a cinema operating at 50% of capacity and 95%
of capacity is virtually nil (the same rent must be paid, the same
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EQUITY INVESTMENTS AND INFLATION
Table 6.2 Carmike Cinemas, Inc: growth in income margin (20014)
2001
Avg ticket price (US$)
Avg concession sales
per patron (US$)
Total attendance (mn)
4.83
2.10
64.261
Revenue (US$ mn)

457.0
Operating costs (US$)
(420.8)
Operating income (US$)
36.2
Interest expense (US$)
(9.1)
Pre-tax income (US$)
27.1
Pre-tax income margin (%)
5.9
2004
Total Annualised
change change
(%)
(%)
5.17
2.33
7.0
10.9
2.3
3.5
63.260
(1.6)
(0.5)
494.5
(423.6)
70.9
(26.1)
44.8
9.1
8.2
0.7
95.9
186.8
65.3
Operating costs exclude impairment of long-lived assets and gains on

sales of property and equipment; pre-tax income excludes loss on extinguishment of debt.
Source: Carmike Cinemas, Inc. 10-K.
minimal staffing is required for the ticket line and concession stands,
and so forth) so that the earnings are highly sensitive to capacity utilisation. The alluring income margin growth rate reported in this table
should not be misinterpreted as representative of the companys (or
the cinema industrys) long-term results, since the 20014 period
was selected specifically to illustrate this form of operating leverage. From this example, it can be seen that, even with slightly lower
attendance at cinemas, a modicum of pricing power, of the order
of 3% per annum, was sufficient to raise pre-tax income by 65.3%
(Table 6.2).
All else being equal, an increase in ticket and concession pricing,
since it requires no increase in operating cost, amounts to a pure
increase in operating profit. If the initial profit margin is relatively
low (in this case about 6%), then pricing power of merely 23% per
year can be sufficient to increase the profit margin by around 50%
or more in a very few periods.
Therefore, equities as a class do have the ability to mitigate
the impact of inflation on purchasing power through the earnings
leverage of a business. Unfortunately, this does not mean that an
investor can automatically capture the inflation effects on earnings
as reported in a companys income statement. Even specific equity
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sectors popularly identified as inflation beneficiaries, the earnings

of which are particularly sensitive to price levels and expand along
with inflation, do not necessarily provide the presumed benefits
during the inflationary periods for which they were acquired. The
reasons for this are discussed in the following.
The impact of rising interest rates and operating costs
To illustrate one of the challenges, imagine that you had the opportunity to be transported back to 1970, yet retain your general historical knowledge of that era. At that time, the price of gold was
approximately US$35 per ounce and, with the advantage of hindsight, we know that 1970s were characterised by intense inflationary
pressure. In particular, it is well known that gold appreciated to well
over US$500 per ounce by the beginning of the 1980s. Cognisant of
these information advantages, should you, desiring to hedge against
impending inflation, have bought Newmont Mining (Newmont),
a gold mining company, in 1970?
The short answer is no. Newmont would not have been as remunerative as we might have expected, despite the extraordinary rise
in the price of gold. At year-end 1969, Newmont traded at a priceto-earnings (P/E) ratio of 12.5.2 The inverse of the P/E ratio, the
earnings yield (1/12.5 = 8.0% for Newmont), is more relevant (in
the sense that it can be compared with the yield on other assets) and
is an indication of the amount of earnings we receive for the price of a
share. This can be directly compared with the yield on fixed-income
securities and interest rates in general. For example, in December
1969, the 10-year US Treasury yielded 7.7%, which was similar to
the earnings yield of Newmont stock.
During the following decade, the price of gold rose dramatically,
and Newmonts earnings rose at a 10.8% annualised rate. However,
in response to inflationary pressure, the 10-year Treasury rate also
rose to 10.4% by December 1979. Similarly, the earnings yield of
Newmont increased as well: in this instance to 17.9%, which implies
that its P/E ratio contracted to 5. 6. In other words, even though the
price of gold and Newmonts earnings increased dramatically, the
multiple that investors were willing to pay for this earnings stream
declined throughout the decade. The increase in earnings was also
limited by the fact that Newmont, in order to replace its depleting gold reserves, had to acquire new properties at a cost that also
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rose with inflation, thereby limiting the potential for margin expansion. During the period, Newmonts share price only increased by
an annualised 2.2% in nominal terms, for a negative return in inflation adjusted terms (annualised consumer price inflation was 7.4%
in the decade from 1970 to 1979).
The key variable in this example was the rising earnings yield for
shares driven by rising interest rates, among other factors, as well
as the negative effect on operating margin due to higher replacement costs. Similar counter-intuitive examples can be found in oil
exploration and drilling companies during periods of rising oil
prices.
The impact of expectations on prices
Another important element is that, in addition to inflation and interest rates, market prices embed expectations about future earnings
and other cashflow streams, and these expectations, whether confirmed by future economic realisation or not, powerfully influence
where stocks trade, over longer periods of time than we have been
taught to believe.
To illustrate this point, we shall examine how Newmont stock performed from 1996 to 2010, again using the literary conceit of perfect
foresight. Say that it could have been known in 1996 that gold prices
would more than triple over the ensuing 14 years (from an average price of US$388 per ounce in 1996 to US$1,216 per ounce in May
2010, for an annualised appreciation rate of 8.5%). As a counterpoint
to the preceding example, though, it is also known that consumer
price inflation would average a mere 2.4%, lower than any year during the prior decade, and that interest rates would actually decline.
Nevertheless, Newmont stock, which traded at US$60.25 per share in
May 1996, was lower, at US$53.82 per share, in May 2010. Therefore,
a seemingly obvious investment in Newmont would have resulted
in a loss in nominal terms and, more importantly, a substantial negative real rate of return over the period considered, despite much
higher gold prices and lower interest rates.
In this example, the limiting variable on the share price was not
inflation or higher interest rates and, consequently, a lower P/E ratio
(higher required earnings yield). Rather, in the 1990s, gold mining companies did not produce significant earnings, so investors
tended to value them based on net asset value. This involves estimating production over the life of the mine (several decades forward),
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projecting the prices at which gold will be sold in the future and subtracting the estimated cost of production to derive the prospective
annual payment streams. A net-present-value calculation is applied
to each of those payment streams, the sum of which would equal,
after allowance for net cash or debt, the net asset value of the company. Using that methodology, at a gold price of US$388, investors
concluded, in aggregate, that fair value in 1996 was US$60 a share.
Yet, by 2010, when mining companies were producing substantial
income, they came to be valued on a price-to-earnings basis, as
opposed to a net-asset-value basis, by which approach investors
concluded that the value of the companys stock was still roughly
US$60, despite gold prices being dramatically higher.
The lesson to be learnt is that even when the earnings of companies
benefit from inflation, if too many investors anticipate a positive
case outcome, that outlook will be largely discounted in their stock
prices, the result being a poor inflation hedge. If the initial valuation
of such a company is too high, there is hardly a realistic level of rapid
earnings growth, even a decade of such growth, that will suffice to
overcome the momentary change in clearing prices that can occur
when investors outlooks change.
In addition, many are the complexities of stock and company valuation. For example, in the period considered, the value of Newmont
as a company, that is, its market capitalisation, did indeed increase
at a double-digit rate. However, this was because of the issuance
of new shares to raise capital. This financing actually diluted the
price per share, which is the only relevant measure to an investor,
contributing to the poor performance outlined above.
The example above highlights how it is not just (inflation) forecasts that count, but their relation to future scenarios embedded in
share prices. Therefore, the true analytical challenge is not merely
finding a company (or type of company) for which a good forecast
can be produced, but finding one that can produce a good forecast
and for which no one else is desirous of, or interested in providing, a good forecast. In other words, the best positioned and best
managed inflation-beneficiary company, if recognised as such and
desired by investors, will paradoxically be priced with a sufficient
premium so as to produce a disappointing return; we must locate an
inflation-beneficiary company whose shares incorporate little or no
expectation of a satisfactory return, because returns are made not on
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paper but in the marketplace, where the attitudes of other investors

affect clearing prices.
In contradistinction, consider Archer Daniels Midland Company
(ADM), a company that performed much better during the period in
question, even though (or perhaps because) it was not considered an
obvious inflation beneficiary. ADM is a processor of commodities,
specifically food products (it mills wheat into flour, corn into cornmeal, etc). The company operates with a very narrow margin of the
order of 2.5% of the value of the commodities processed. Therefore,
on a bushel of wheat valued at US$1, the company might make 2.5.
At US$2 per bushel, though, it might earn closer to 5. At higher
prices, the company can make substantially more money, even if the
margin remains fixed.
At the beginning of the 1970s, ADMs P/E ratio was about 10,
equivalent to an earnings yield of 10%, and it was the same at the
beginning of the 1980s.3 In other words, the ADM share price did not
suffer from the contraction of valuation multiple that afflicted Newmont, and as its earnings increased (at an average of about of 20%
per annum) its share price rose as well, and its market capitalisation
rate remained about the same in spite of generally higher interest
rates (which increased over the period).4 Though perhaps not obvious from the conventional view of what constitutes a good inflation
hedge, ADM was a much more successful investment than Newmont. The heuristic gold company equals good inflation hedge
did not provide the returns that Newmont shareholders expected
during the high-inflation period in question.
The lesson of Newmont and ADM should not be lost on the
investor: inflation and its effects on each individual companys share
price are complex and difficult to ascertain, even if the future rate
of inflation, interest rates and commodity prices were known in
advance, which of course is not the case.
A SENSIBLE APPROACH TO EQUITY INVESTING AND
INFLATION
It is our view that basing investment decisions on future forecasts of
inflation is fraught with danger. First, the confidence we can have in
such a market forecast is limited; second, as illustrated by the two
examples in the previous section, an investor might get the forecast
right, yet still get the investment vehicle wrong.
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One approach towards managing the risk of inflation is to make

investments that do not necessarily rely on a specific inflation rate
to be remunerative, but that will benefit if inflation were indeed to
occur. In this way, the expected outcome is not a binary event. This
approach hinges on a companys ability to produce an adequate
return on its capital irrespective of the inflationary environment,
while maintaining a positive correlation with general price levels.
In the following, we shall analyse several equity sectors that might
provide such attractive characteristics.
Royalty companies
Aprime example of companies that incorporate this dynamic are precious metals royalty companies such as Franco-Nevada and Royal
Gold. These companies are, essentially, unleveraged finance businesses that engage in very particular types of transactions with gold
producers and, to a lesser extent, with oil exploration companies.
They do not conduct mining operations themselves, nor do they
make conventional equity investments. This form of business was
born of the distinct project-financing challenges faced by extraction
companies. In fact, even if there is certainty of the future productivity
of an undeveloped deposit, a gold miner cannot typically afford to
take on too much debt, because the capital costs can be substantial,
and a very long time is generally required to reach the stage when
commercial production can start. During this time, output prices
and input costs can vary dramatically enough to threaten a debtfinanced miner. Likewise, if the share price is too low, issuing new
equity is excessively dilutive.
Royalty companies devised an elegant solution for the specific
project-financing needs of these resource extraction companies.
In simple terms, a royalty company purchases a revenue stream
derived from the sale of the precious metal or oil to be extracted by
the company (eg, gold in the case of Newmont). Consequently, the
revenues from these contracts are independent of either the profitability or the share price of the miner, as long as the underlying commodity is extracted and sold. Specifically, the royalty company pays today the net present value of the commodity to be produced by the extraction company at some time in the future. As
a hypothetical example, Franco-Nevada might agree to pay Newmont the prevailing price of gold at the time of writing in 2011:5
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Table 6.3 Franco-Nevada and Newmont equity prices versus gold price
Franco-Nevada
Mining Corp
(US$)
Newmont
Mining
(US$)
Gold
(per oz)
(US$)
Dec 30, 1983

Dec 28, 2001
0.20
23.10
4.23
17.71
382.40
278.95
Annualised change (%)
30.2
8.3
1.7
This is the old Franco-Nevada, for which the earliest share price available is in October 1983, and which was acquired in February 2002 by Newmont Mining. Franco-Nevada became public again in December 2007.
Source: Bloomberg.
US$1,500 per ounce (to use a round figure), discounted at a fixed

interest rate, say 10%. Thus, the first year production is sold today
at US$1,363 = US$1,500/1.1; the second year production is sold at
US$1,240 = US$1,500/(1.1)2 , and so on. For the 30th years output,
Franco-Nevada will have paid, in advance, only 5.7% of the current market price of that gold. Accordingly, if the price of gold does
not change in the future, and the gold mining company produces
the expected amount of gold (even if at break-even or a loss), the
rate of return the royalty company would realise would be the discount rate applied to the original investment, which in this example
is 10%. Contrast this with purchasing gold outright, either through
an exchange-traded fund (ETF) or the physical commodity itself.
Whereas a flat gold price would produce a zero return in a direct
purchase of the commodity, the royalty company would still generate a return equivalent to the discount rate. If the price of gold were
to rise, a holder of physical gold would receive a return equivalent
to the rate of appreciation on the commodity. However, assuming
no hedges are in place, the royalty company would receive the rate
of return on the underlying commodity on top of the original discount rate. Of course, this can go both ways, but note that if a royalty
company purchases production at a discount of 10% over 30 years, it
can actually sustain a 10% decline in gold prices each and every year
over a 30-year period without incurring a capital loss. This is simply not possible through a direct investment in the precious metal,
or in a mining company (or in virtually any other industry, for that
matter).
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Finally, it is not unusual for these financing contracts to include

a rate adjustment linked to the price of the underlying commodity, such that the royalty company can receive incremental royalty
income should the sales price of the mining companys ore rise above
certain predetermined benchmarks.6 Table 6.3 shows the impressive
return of Franco-Nevadas share price over a period of almost two
decades. This exceptional performance occurred in spite of declining gold prices (the point-to-point decline was 26%, as displayed in
Table 6.3, and the average year-end gold price from 1983 to 2001,
inclusive, was US$354, or 7% lower than the 1983 price),7 and was
based on the discount rates on the financing contracts offered to
Newmont.
Spread-based companies
Another sector that can prosper in an inflationary environment is
comprised of companies that are able to pass through the costs of
inflation via a spread-based business by charging a fixed percentage fee for their products and/or services. Companies such as the
aforementioned ADM and MasterCard belong to this sector.
The case of MasterCard is interesting because this company is
often (erroneously) categorised as a financial institution, similar to
banks and other companies that lend money. In reality, MasterCard is
simply a processor; it does not issue credit cards, it simply processes
the transactions made on credit cards bearing its brand. The companys revenues derive from two sources: a fixed US dollar fee per
transaction, and a small percentage fee based upon the transactions
US dollar value.
For illustrative purposes, let us say that MasterCards percentage
fee amounts to 1% of the US dollar value of each transaction, so that
a purchase of US$100 would generate a fee of US$1 (in reality, MasterCards percentage fee averages a small fraction of 1%, applied to
trillions of US dollars in transactions). If a products price were to
increase by, say, 10%, care of inflation, the total value of the purchase would be US$110, with a proportionate increase in the fee to
US$1.10. Accordingly, a company such as MasterCard, which operates a spread-based business, is somewhat immunised from inflation. Indeed, it might actually benefit from a general rise in the price
of goods and services. In this much simplified example, the 10%
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Table 6.4 Wilshire US Real Estate Securities Index versus S&P 500
period return (June 2007 to June 2011)
Period return (%)
Wilshire US Real Estate

Securities Index
S&P 500
Index
2.6
4.1
increase in revenue requires no direct increase in the number of personnel, computer processing capacity, office space or other expenses
and thus should be particularly profitable.
Real estate companies
Although the real estate industry experienced much distress during
the 20089 financial and housing crisis, this episode has not invalidated real estate as an inflation beneficiary. Indeed, from the beginning of that period up to and including June 2011, real estate stocks
did not underperform broad stock indexes, irrespective of their more
dramatic interim decline. Table 6.4 shows a comparison of returns
between the general US equity market as measured by the S&P 500
Index and the Wilshire US Real Estate Security Index8 , which is a
composite of publicly traded Real Estate Investment Trusts (REITs)
and Real Estate Operating Companies (REOCs).
There is a certain structural limitation to the ability of REITs to
compound their per-share value, since by regulation they must distribute as dividends substantially all of their income. As a result,
they must issue additional shares in order to acquire new properties, and there are periods when the cost of new equity capital
will be disadvantageous. Non-REIT real estate companies can reinvest their income and are less dependent upon the public market
for growth capital. Therefore, we might be better advised to concentrate on select commercial real estate companies, with strong balance
sheets and unique income-producing properties. Aside from their
fundamental investment merits, these companies provide inflationhedging benefits through multiple modalities. First, inflation typically increases the value of the underlying real estate properties,
so that such a companys net asset value tends to rise in inflationary periods. Second, as their commercial leases approach renewal,
higher prices can be charged to reflect the effects of inflation on
prevailing rental rates. Finally, real estate companies typically use
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leverage to purchase their properties. To the extent that the mortgage payments are fixed, their liabilities will decrease in real terms
because of higher inflation. In this sense, leveraged companies
in general can benefit an investment portfolio during inflationary
periods.
Leveraged companies and deleveraging mechanisms
Leverage is an important element when evaluating an equity investment. In this section, we shall explain how changes in leverage can
affect the value of a company and thus its stock price. The first mechanism is directly related to inflation and the operational leverage (ie,
higher operating margin) that comes with higher output price levels
relative to a fixed cost structure. The next mechanism is linked not
to inflation per se or to a higher operating margin, but to the expansion in earnings that results from deleveraging, ie, paying down the
debt and reducing interest costs. There is also a market-based mechanism, whereby a companys stock market valuation can rise as a
direct function of its paying down debt. All three mechanisms are
important and can be present at the same time; thus, they are covered
in this section.
We have already discussed how inflation and higher output
prices (versus a fixed cost structure) can result in considerably
higher income margins (Table 6.1). In essence, rising sale prices
provide a form of operating leverage, as they do not require additional resources (such as sales personnel, manufacturing capacity
or other production inputs), and thus do not increase variable costs
(as opposed to rising unit sales). This effect can be amplified by
the presence of fixed-rate leverage as well, since inflation favours
the fixed-rate debtor over the creditor. In that relationship, each
years interest payment remains constant, even as sales revenue
and, presumably, earnings rise in concordance with rising price
levels.
The fact that inflation favours the fixed-rate debtor, due to the
fact that the interest is fixed in the face of overall rising prices, is a
theme that applies beyond publicly traded equities. In fact, one of
the most effective inflation hedges during the inflationary decades
of the 1970s and 1980s was the 30-year fixed-rate home mortgage.
Specifically, from 1973 to 1982, a mortgagors fixed-rate payment
cheapened by 8.7% per annum in inflation-adjusted terms (using the
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average Consumer Price Index (CPI) inflation rate over the period).9
In other words, by the end of the 10-year period, a homeowner would
have been making mortgage payments at 45 = 1/(1.087)10 cents on
the dollar in real terms. In addition, over the same period, they would
have received higher wages and a higher value for their house, in
sympathy with other price levels.
Although fixed-rate leverage amplifies the positive effects on
operating margin of higher output prices, it is the deleveraging of
a company that often offers attractive investment opportunities. In
particular, a company with a high level of fixed-rate leverage, but
in the process of entering a deleveraging phase, might offer the best
of both worlds, ie, attractive performance prospects combined with
protection from rising price levels.
Take the example of a company with a stable business, which
employs its earnings to reduce its debt (through plainly using the
companys earnings to pay down its debt, in the same way that
an individual might use their salary to pay down their credit card
debt).
Initially, we shall assume zero revenue growth (Table 6.5) and
a constant operating margin (no operating leverage) to isolate the
effect of debt reduction. As liabilities are paid down each year,
the interest expense associated with debt is also extinguished. This
leaves more after-tax income available the next year, so that a yet
larger amount of debt may be paid down. This process creates
an increase in net income, which compounds over time (for an
annualised rate of 4.9% in the decade considered).
Table 6.6 presents an additional example, this time with a modest rate (3% per annum) of revenue expansion, but still no operating
leverage (the operating margin is constant at 20%), for an annualised
income growth of 12.7% over the period. In practice, few companies
sustain a linear path of any sort for a whole decade, but the previous examples serve to illustrate the degree to which merely the
two factors of persistent interest expense reduction and the operating leverage of price-inflated revenues can serve the cause of value
creation in a leveraged company.
However, a third and probably the most powerful equity value
creation dynamic from the deleveraging process is expressed by
the MillerModigliani invariance theorems (Modigliani and Miller
1958). These state, in part, that the enterprise value of the firm (that
91
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i
Interest
expense
(US$ mn)
Pre-tax
income
(US$ mn)
Income
net
of tax
(US$ mn)
Debt
(US$ mn)
0
1
2
3
4
5
6
7
8
9
10
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
0.0
200
200
200
200
200
200
200
200
200
200
200
0.0
(150)
(148)
(145)
(142)
(140)
(137)
(133)
(130)
(127)
(123)
(120)
(2.2)
50
52
55
58
60
63
67
70
73
77
80
4.9
33
34
36
37
39
41
43
45
48
50
52
4.9
2,000
1,968
1,933
1,898
1,860
1,821
1,780
1,736
1,691
1,643
1,594
(2.2)
Interest
coverage
ratio
1.33
1.36
1.38
1.41
1.43
1.46
1.50
1.54
1.58
1.62
1.67
perrucci 2012/7/11 17:12 page 92 #114
Year
Revenue
(US$ mn)
Operating
income
(US$ mn)
92
Table 6.5 The effects of deleveraging with no revenue growth/no operating leverage
We make the following assumptions. Revenue growth: 0%. Operating margin: 20%. Debt interest rate: 7.5%. Income tax rate: 35%.
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Table 6.6 The effects of deleveraging with modest revenue growth/no operating leverage
Pre-tax
income
(US$ mn)
Income
net
of tax
(US$ mn)
Debt
(US$ mn)
0
1
2
3
4
5
6
7
8
9
10
1,000
1,030
1,061
1,093
1,126
1,159
1,194
1,230
1,267
1,305
1,344
3.0
200
206
212
219
225
232
239
246
253
261
269
3.0
(150)
(148)
(145)
(141)
(138)
(133)
(129)
(123)
(117)
(111)
(103)
(3.7)
50
58
67
77
87
98
110
123
136
150
166
12.7
33
38
44
50
57
64
72
80
88
98
108
12.7
2,000
1,968
1,930
1,886
1,836
1,779
1,715
1,643
1,563
1,475
1,377
(3.7)
Interest
coverage
ratio
We make the following assumptions. Revenue growth: 3%. Operating margin: 20%. Debt interest rate: 7.5%. Income tax rate: 35%.
1.33
1.40
1.47
1.55
1.64
1.74
1.86
2.00
2.16
2.36
2.60
perrucci 2012/7/11 17:12 page 93 #115
Interest
expense
(US$ mn)
93
Year
Revenue
(US$ mn)
Operating
income
(US$ mn)
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is, the sum of its debt and equity) is invariant (under certain assumptions) to the capital structure of the firm. This presumes that companies are valued in the marketplace on an enterprise value basis,
irrespective of the distinction between debt and equity. Accordingly,
if a company has a low stock market capitalisation in relation to its
debt, and if it uses its cashflow to reduce debt, the equity value
should increase by a like amount such that the total enterprise value
remains unchanged. As a conceptual test, were this not so, then a
highly leveraged company that repays debt would find its enterprise
value contracting, which is to say that investors would penalise the
company for reducing its financial risk.
In our experience, deleveraging companies exhibit such distinctive characteristics that they deserve their own sector classification.
In other words, companies in separate sectors yet with common
balance-sheet structures and debt reduction strategies will share
greater return commonalities than many companies in the same
sector but with different balance-sheet arrangements (however, the
unfolding of events over a span of years is rarely cleanly reducible
to the single variable). A clean, simple example of debt reduction
without any meaningful intrusion of other balance-sheet/operating
issues, would be Church & Dwight. However, in this case, its starting
point was leveraged only on a balance-sheet basis, not on an income
statement/interest coverage basis. Therefore, it was not obviously
undervalued at the start, and its share price appreciation over time
was more a function of its business expansion than its balance-sheet
improvement (Table 6.7).
As shown in Tables 6.5 and 6.6, investing in companies that are
entering a deleveraging phase can provide very rewarding returns.
An additional benefit from investing in deleveraging firms is that
returns tend to be less correlated to exogenous events such as the
economic cycle or the competitive environment, since the equity
value expansion is largely a function of the debt reduction process
itself. Furthermore, these companies have typically established their
competitive positions already, and do not need to incur the costs (and
uncertainties) required to gain market share or develop a new product. Clearly, the objective should be to select companies with stable
businesses, good management and for which leverage has not been
the result of deteriorating fundamentals, but the most effective strategy to finance the business, and enhance returns on equity. As with
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Sep 2011
Dec 2010
Dec 2009
Dec 2008
Dec 2007
Dec 2006
income.
Book
value
(US$ mn)
Debt/
equity
(%)
Sales
(US$ mn)
254
340
816
856
856
933
2,086
1,871
1,602
1,332
1,080
864
12
18
51
64
79
108
2,704
2,589
2,521
2,422
2,221
1,946
Interest
expense
(US$ mn)
10
28
36
47
59
54
Operating
income
(US$ mn)
Interest
savings
(%)
Interest
coverage
ratio
Book value/
share
(US$)
457
445
413
340
305
252
142
24
16
34
9
45.8
16.0
11.6
7.2
5.2
4.7
29.10
26.34
22.76
19.62
16.41
13.31
operating income and interest expense for 2011 based on nine-month results, annualised.
As
a percentage of change in operating
95
Sales,
Total
debt
(US$ mn)
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Table 6.7 Church and Dwight (CHD) deleveraging process
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any other publicly traded security, investing in leveraged equities

requires a considerable amount of analysis and scrutiny, including
consideration of both quantitative and qualitative aspects. Indeed,
investing in deleveraging companies is similar to the business of
a leveraged-buy-out (LBO) firm, which will typically acquire an
undervalued company with reasonably stable cashflows (borrowing
against the acquired companys balance sheet and future cashflows)
and then spend several years in debt-reduction mode, before selling
the company to the public, or a strategic investor, once again.
Busted convertible securities
Traditionally, convertible securities (ie, bonds or preferred stock)
have been employed as equity alternatives, for reasons described
below. This periodically creates a pricing opportunity that permits a
convertible to be used in a different and, we believe, more effective
fashion.
Companies issue convertibles securities as a way to reduce their
borrowing costs. As an illustration, consider an A-rated corporation
that can issue a bond at a 5% interest rate, versus a lower credit
rated company, say BBB, which would have to pay 7% on a bond of
similar maturity.10 The BBB-rated company might opt to sell a bond
with an equity conversion feature as an inducement to a different set
of buyers. Specifically, it might issue a convertible bond at a lower
(5%) interest rate, yet for which the buyer also receives an embedded call option on the company stock. Usually, this type of issuance
occurs when the companys shares have experienced some positive
appreciation, since this is the time when its convertible security is
more likely to be perceived as being attractive from the perspective of optionality, due to the fact that a call option is about the
upside. Typically, the call option embedded in the convertible bond
has a conversion price (strike in traditional option terminology)
higher than the current stock price (2030% being a common range
of the premium to market, depending on the maturity of the security and market conditions). Several structures might be issued, with
the option exercisable only at bond maturity (similar to a European
option) or at a discrete set of future dates. A variation on the same
theme occurs when a company issues convertible preferred stock.11
In summary, convertibles are hybrid fixed-income/equity securities that permit the investor to potentially benefit from appreciation
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of the stock while retaining the interest income stream, final maturity (unless a perpetual preferred, ie, a preferred stock with no final
maturity) and superior capital position and legal rights of traditional debt. For these reasons, convertibles are conventionally used
as a conservative equity substitute.12
Yet, in practice, when a convertible security is sold, two premiums
are paid: a premium to the common share price13 and the share price
itself, which is likely to have already appreciated to a fair degree.
Moreover, in comparison with other bonds, it provides a belowmarket yield as a trade-off for its optionality. Accordingly, whatever
the future return prospects might be, we cannot say that, on a probabilistic basis, the riskreward trade-off favours the buyer. Moreover,
in comparison with other bonds, it provides a below-market yield as
a trade-off for its optionality. Accordingly, whatever the future return
prospects might be, we cannot say that, on a probabilistic basis, the
riskreward trade-off favours the buyer. If for no other reason than
mean reversion behaviour, much less the normal vagaries of the market, there is a reasonable (perhaps more than reasonable) chance that
the underlying shares may decline sharply at some point.
If the shares do decline sharply, the bond, which was originally
priced relative to the share price, will fall as well. So long as creditworthiness is not at issue, the bond should decline only to a price
that provides the same 7% yield at which the company would have
had to issue a conventional bond. It is now a busted convertible
and it still retains the embedded equity option, although this will
have fallen very far out-of-the-money. It now has more intriguing
characteristics.
Let us observe an example of such a cycle from start to finish. Consider XYZ Corporation (XYZ), a well-regarded growth14 company
with a BBB credit rating, which is considering obtaining financing in
the market for a term of 10 years. Given its credit rating, XYZ could
issue a traditional bond (at par), paying an interest rate of 7% per
annum. Fortunately, the XYZ shares have recently appreciated from
US$20 to US$30. Let us say that US$20 was an appropriate valuation at the time, based on generally accepted metrics, and that US$25
was appropriate enough as a forward value, but that US$30 could
be deemed excessive.
XYZ Corp capitalises on this opportunity by issuing a con-
vertible note. The note is priced with a 5% coupon, is due

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in 10 years and is convertible into common shares once they

appreciate by 25% (from the current price of US$30 to a conversion price of US$37.50). Dividing the US$1,000 face value of
each bond by the US$37.50 conversion price, the note holder is
entitled to receive 26.67 shares of stock, upon conversion, for
each US$1,000 face value of bonds held.15
Suppose that, during year 1, the stock falls sharply to US$15,
or by 50%.
The price of the convertible security at year 1 is still the sum of
the discounted value of the conventional bond cashflows plus

the equity options, but given the sharp decrease in share price,
the convertible is busted and falls to a yield-to-maturity
equal to the conventional bond,16 ie, 7%, which equates to a
price of 86.97. While a US$1,000 notional amount of the convertible bond is now priced at US$868, the underlying shares,
having fallen by so much more, are priced at only US$400 per
bond (26.67 shares US$15). The conversion premium17 has
expanded from 25% to 117%.
At this point, from the perspective of the original buyer, these
notes are no longer suitable. They served one purpose in having outperformed the underlying stock in the decline but, at
a 117% conversion premium, they no longer contain much
optionality or equity sensitivity. The shares would have to
nearly double in value for the convertible equity sensitivity
to be restored to levels similar to those at inception.
However, at this same point the busted convertible does have
intriguing characteristics from the perspective of inflation mitigation, depending upon the characteristics of the issuing company and
its equity. Used in this way, busted convertibles function more as
bond substitutes than equity substitutes. In the favourable case, the
assessment might be as follows.
The busted convertible note now has the full bond yield that
the company would have to offer for a conventional bond (7%

in this example).
The busted convertible also provides a free (or nearly
free) warrant. Although, given the 117% conversion premium,

there is little near-term possibility of meaningful equity-based
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appreciation, most fixed-income investors do not require the

significant levels of appreciation sought by equity or most
convertible investors. The busted convertible still has nine
years of optionality remaining. If viewed from a fixed-income
investors perspective, the extended time frame has great utility, whereas for a typical equity investor that time frame is
meaninglessly long.
For instance, what if, by the end of year 2, the common shares were
to recover to a price of US$25, the fair value originally expected for
that time frame, but still well below the US$30 that was considered
excessive at the time the bonds were priced? If the shares were to then
appreciate, on average, by 8% per annum, their price at the time the
bonds mature at the end of year 10 would be US$46.27 = 25 (1.08)8 .
At that price, the equity value of the bond would be US$1,234 =
26.67 shares US$46.27. This amount would represent appreciation
of 23.4% above the US$1,000 maturity value of the bond, for an additional 2.4% per annum above the 7% yield to maturity, and a roughly
9.4% annualised return.
We can contrast the prospective return profile of a busted convertible with that for a common stock. A common stock with no dividend must rely, all things being equal, on 10% annualised earnings
growth in order to provide a double-digit rate of return. To achieve
this return, there must be no share dilution, such as from the exercise of employee options, and it must be accomplished in the face of
competition for market share, possible pricing competition, changing economic conditions and other challenges. There must be no
compression in the P/E multiple (as a lower P/E multiple generally
implies a lower price). This superior rate of return is matched by few
companies. If the S&P 500 Index is a suitable measure, the earnings
growth rate for the companies comprising the index over the 30-year
period ending in 2010 was less than 6%.
All that is required for the busted convertible of the example
above to produce at least a 7% annualised return is the solvency of
the issuer: nothing else. In order to achieve a total rate of return of
10%, from the position of fair value (US$25 at year 2 in our example),
the share price would need to appreciate by 8.75% per year:
US$25 per share, compounded at 8.75% for eight years =
US$48.91;18
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US$48.91 26.67 = US$1,304 equity conversion value at
year 10, ie, a 30.4% additional principal return;

30.4% earned over the nine years that the bond is held is
equivalent to 3.0% per annum of appreciation above face value.

Total return = conventional bond return (7%) + equity-driven
return (3%) = 10%

Thus, an equity-like (double-digit) return can be achieved with
the income, credit and legal claims benefits that otherwise redound
to a bondholder.
There is a subset of convertible securities that can offer inflation
protection even when trading close to par. This is the case for longmaturity convertibles issued by companies that are inflation beneficiaries. An example of such a security is the perpetual19 convertible
preferred share issued in June 2011 by Bunge Limited. Bunge, like
ADM, is also one of the worlds major processors of agricultural commodities, such as grains and oil seeds. This preferred was priced just
above its notional value, at 100.35, and has an annual dividend of
4.875%, which is a bond-level yield, versus the common stock yield
of 1.5%. The conversion premium on the issue date was 33%. Since
by definition there is no maturity date for a perpetual security, there
is a great deal of time for even a modest earnings growth rate to
cumulate sufficiently to ultimately realise the optionality inherent
in the security. If, to distort the manner in which conversion premiums operate in order to make a point, Bunge were to improve
its earnings by merely 6% per year over the course of five years,
the conversion premium would, in a sense, be fully amortised, and
any further growth would inure entirely to the preferred holder. In
the case of Bunge, a positive variable would be an environment of
inflating food prices, in which case the earnings growth rate could
expand at a yet greater rate.
CONCLUSIONS
In this chapter we discussed the many factors affecting equity prices
and several investment strategies that can help to protect the real
value of assets from the effects of inflation.
The complexities of inflation and how certain equity investments
might mitigate its effects are not always as obvious as they may seem.
In fact, while equity prices are generally thought to incorporate an
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inflationary component, the process of exploiting this relationship

can often prove counterintuitive.
To conclude the chapter, we reiterate a point that was made during
the discussion of the impact of expectations on market prices. In
particular, return forecasts must be compared with the expectations
embedded in the market price of securities. For example, if inflation
is widely anticipated and if gold royalty companies become a focus
of investors attention, then their share prices might not provide an
attractive riskreturn profile after all. By the same logic, the best time
to acquire inflation protection is often when inflation is not widely
anticipated, or when a given sector or instrument is not in favour,
which is to say that its fundamental merits are not fully reflected
in its market price. Accordingly, there is no single security, security
type or industry sector that can be relied upon at will. It is critical
that investors have a valuation methodology (or, even better, a range
of methodologies) to be able to assess with relative confidence the
value of any potential investment in the context of its expected future
returns in several circumstances.
1
Carmike Cinemas, Inc (ticker CKEC), one of the largest cinema operators in the US is used
here, as it has the longest history of public ownership (according to company 10-K filings). In
fact, Carmike Cinemas has not thrived, though for other reasons related to secular challenges
to this particular business model.
Data for Newmont and Franco-Nevada from 1983 and later is sourced from Bloomberg LP,
which is a generally accepted data aggregator source. Data before 1983 was obtained from
the company. Gold prices are sourced from Bloomberg LP.
Being low-profit-margin intermediaries, interim changes between input costs and output
prices can have a large impact upon year-to-year profitability for grain processors like ADM.
To provide figures more representative of normalised earnings, the three-year average P/E is
used here: 10.4 times for the three fiscal years June 1970 to June 1972; 10.0 times for the three
fiscal years June 1980 to June 1982.
The market capitalisation rate is the rate used to discount future cashflows in the net-presentvalue formula for the share price, or also the market expected yield on the equity investment.
Use of the current prevailing commodity price is typical in these financing contracts.
Often, the royalty contract will contain a schedule such that at the initial gold price, say
US$1,000, the royalty rate might be 2%; at a higher gold price, US$1,100, the rate will be
higher, say 2.5%, and so forth. It is designed in part to limit costs to the miner in the early
production phase, and to generate additional returns for the royalty company in a more
favourable environment for the miner.
Generally, Franco-Nevada neither hedges nor employs debt leverage.
http://www.wilshire.com/.
The CPI is published by the US Bureau of Labor Statistics.
10 These are the credit ratings issued by Nationally Recognized Statistical Rating Organizations
(NRSROs) such as Moodys, S&P, Fitch, etc.
11 This is preferred stock with an embedded option of conversion into common shares. In practice, convertible preferred stock can be seen as a long-maturity convertible bond, but with
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higher credit risk, given its junior position in the capital structure relative to debt, ie, preferred
stock with an embedded option of conversion into common shares.
12 Depending on market conditions (interest rates, credit spreads and stock prices in particular),
a convertible security might, over time, behave more like a bond or more like a stock, and
thus offer distinct properties and attract interest from different sets of investors at different
times.
13 As mentioned before, the conversion price is typically higher than the current share price.
14 A growth stock is from a company that is expected to grow its earnings and/or revenue faster
than its industry sector or the overall market.
15 The convertible bond can be written as a conventional bond (paying a coupon of c = 5% and
priced at a yield of y = 7%) plus 26.67 equity calls.
16 Assuming a flat and unchanged credit curve for the issuer in question, ie, XYZ Corporation.
In reality, a plunge in stock price would typically imply wider credit spreads.
17 The conversion premium is given by (convertible price/conversion value) 1, where the
conversion value is the value that could be realised by converting into shares immediately.
In our example, the convertible price is US$868, and the conversion value is 26.67 shares
US$15 price per share = US$400. Thus, the conversion premium is (868/400) 1 = 117%. The
higher the conversion premium, the lower the equity sensitivity of the convertible.
18 Average equity appreciation over the nine-year period (from year 1, when the busted
convertible is bought to maturity at year 10) is 14% per annum.
19 This means that, contrary to a convertible bond, there is no maturity date when notional will
be returned.
REFERENCES
Modigliani, F., and M. H. Miller, 1958, The Cost of Capital, Corporation Finance and the
Theory of Investment, American Economic Review 48(3), pp. 26197.
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Inflation-Linked Markets
Gang Hu; Stefania Perrucci
Credit Suisse; New Sky Capital
Since 1981, when the UK government issued the first inflation-linked

bond (linker),1 the linker market has established itself as a distinct
asset class within the global fixed income universe. With a market
notional close to US$2.5 trillion outstanding (Table 7.1), including
both developed and emerging countries, this asset class has attracted
a variety of market participants, ranging from asset managers, retail
investors and pension funds to central banks. In addition to this
global bond market, liability-matching programmes in the European Union (EU) and the UK and corporate issuance in the US
have planted the seeds for the development of a growing inflation
derivatives market, which has quickly gained global acceptance and
liquidity.
In this chapter, we focus on inflation-linked bonds and linear inflation derivatives. The first two sections provide a brief recap of the
different characteristics of linkers, and give a specific example introducing some key concepts and illustrating trading conventions for
US Treasury Inflation Protected Securities (US TIPS). Next, we discuss the macroeconomic variables affecting real rates, the investment
allocation process and both fundamental and technical factors which
typically drive investment opportunities in the inflation-linked bond
market. Finally, inflation derivatives and inflation-linked bonds
issued by municipalities and corporates are introduced, and their
role as important tools in the investors arsenal is explained. A brief
summary section concludes the chapter.
INFLATION-LINKED BONDS
Inflation-linked bonds are designed to compensate investors for the
loss in purchasing power caused by changes in overall price levels (Bnaben 2005). To this end, coupon and principal payments are
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linked to an inflation index. Both developed and emerging market

governments and non-government entities have issued inflationlinked bonds, although the level of activity and liquidity varies for
each local market. Issuers of linkers include the US, the UK, several
Eurozone countries (eg, France, Germany, Greece and Italy),2 several
Latin American countries (eg, Mexico, Brazil, Argentina, Colombia
and Chile), several Asian countries (eg, Japan, South Korea and Thailand), Canada, Sweden, Denmark, Iceland and Australia, as well as
several countries in Eastern Europe (eg, Poland), the Middle East
(eg, Turkey) and Africa (eg, South Africa).
The reasons for either issuing or investing in inflation-linked
bonds are several. Issuers might be able to lower their cost of debt
by exploiting the positive inflation risk premium3 between nominal
and inflation-linked bonds. Furthermore, by issuing inflation-linked
bonds, a government might also help to establish market credibility
for its monetary policy, and thus indirectly lower the cost of its nominal debt as well. In addition, owing to the inflation protection offered
to investors, a government might be able to extend the maturity and
cashflow profile of its liabilities; for example, countries like Mexico
and South Africa were able to issue long-term inflation-linked debt
well before they could issue nominal debt at comparable maturities.
Indeed, for many emerging market economies traditionally plagued
by high levels of inflation, linkers have been an effective way to
decrease hard currency (dollar) funding and increase investors
participation in domestic, local-currency-denominated debt.
Assetliability management is also a key consideration for both
issuers and investors in the space. Issuers will have an incentive to
use inflation-linked debt if their revenue is implicitly or explicitly
linked to price levels. Clearly, this is the case for governments, for
whom taxes are the principal revenue source. In addition, since inflation tends to be positively correlated with the real economy, inflationlinked liabilities will also have a stabilising effect on the government
fiscal budget, as debt service levels and tax receipts will tend to
move in the same direction. Several corporations, particularly in the
infrastructure and energy sectors, also have revenues linked to price
levels and often issue inflation-linked debt. Finally, assetliability
management also drives considerable interest from investors whose
liabilities are linked to inflation, particularly insurance companies
and pension funds.
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INFLATION-LINKED MARKETS
It is worth noting that many governments globally have recently

stepped up linker issuance efforts. This reflects not only the increased
funding needs following the financial crisis of 200811, but also
surging demand from investors, given the uncertainty surrounding
inflation in this environment.
As mentioned before, inflation-linked bonds provide coupon and
notional payments, which are linked to an inflation index, with a
time lag that goes from a few weeks to a few months depending
on issue and country of issuance. Some, but not all, also have an
embedded notional floor struck at par, eg, US TIPS. A few, for example, Australian government linkers, also have coupon floors. Original maturities range from 1 to 45 years. Each inflation market has its
own specific characteristics, as detailed in Table 7.1. We next introduce some key concepts and definitions, using the largest and most
liquid market for linkers, ie, US TIPS, as an illustration. With the
necessary modifications, analogous concepts and mechanisms are
applicable to other global linkers.
US TREASURY INFLATION PROTECTED SECURITIES
In a US Treasury Inflation Protected Security, the bond notional is
indexed to the non-seasonally adjusted Consumer Price Index (CPI)
for all Urban Consumers, published monthly by the US Bureau of
Labor Statistics (BLS).4 The US Treasury Inflation Protected Security pays a fixed rate coupon semi-annually on a notional, which is
indexed to the CPI. At maturity, as well as the last coupon, the fully
indexed notional is paid, and the latter is floored at par. This means
that the notional redemption at maturity cannot be less than 100%
of notional at issuance, even if the cumulative inflation rate over the
life of the security is negative (this is why it is called deflation floor).
Historically, the reason behind this feature has not been investors
concern about deflation risk (which came to the forefront only during
the global financial crisis of 200811), but the preferred accounting
treatment of assets with principal guarantee, which usually are not
required to be marked-to-market, thus avoiding the related income
volatility (Bnaben and Goldenberg 2008).
Since coupon and notional payments are indexed to inflation, an
inflation-linked bond provides a fixed real rate of return (if held to
maturity, and with index-lag considerations aside). In other words,
105
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Market
No. of
bonds
US
UK
France
31
16
12
Brazil
Italy
13
9
Index
US CPI NSA
RPI
French CPI ex-tobacco
Euro HICP ex-tobacco
IPCA Index
Euro HICP ex-tobacco
Lag
(months)
Coupon
frequency
Deflation
floor
Market
size
(US$ bn)
Maturity
range
(yr)
23
8 or 23
23
Semi-annual
Semi-annual
Annual
Par
None
Par
643
392
222
130
145
130
Up to four weeks
23
Semi-annual
Semi-annual
None
Par
210
143
140
130
CPI, Consumer Price Index; NSA, non-seasonally adjusted; RPI, Retail Price Index; HICP, Harmonized Index of Consumer Prices;
IPCA, ndice Nacional de Preos ao Consumidor Amplo.
Source: data from Bloomberg, Credit Suisse, New Sky Capital. Data is as of June 2011.
perrucci 2012/7/11 17:12 page 106 #128
106
Table 7.1 Major government inflation-linked market characteristics
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a linker is a real rate product whose market price does not depend
on inflation,5 although its nominal return of course does.
We next discuss the trading and settlement mechanisms for US
TIPS. As a concrete example, consider the US TIPS issued in April
2011, with a 0.125% fixed coupon (semi-annual compounding) and
maturity of April 15, 2016. On Wednesday, October 12, 2011, its
quoted (clean) price was Q = 103 4+.6 Settlement convention is
T + 1, meaning that the trade will settle on Thursday, October 13
(this will be set to t = 0 in the formulas below), when the full (dirty)
price P will be exchanged for the bond. For a US Treasury Inflation
Protected Security, the full price P is given by
P(0) = (Q(0) + AI(0)) IR(0),
where IR(0) =
CPI0
CPIbase
where Q is the quoted price, AI denotes the interest accrued from

the last coupon payment date to the settlement date and IR denotes
the index ratio.
Accrued interest is calculated from the last coupon payment (the
issue date in our example) to the settlement date, using an actual/
actual day-count convention. In our example, there are 151 days
between April 15 and October 13, and the next coupon date is October 17 (since October 15 is a Saturday). The IR is defined as the ratio
of the daily reference index value at settlement, ie, CPI0 , and at bond
issuance (the base index CPIbase ). The daily reference index value at
any given date is the result of an interpolation between the index
value with a three-month lag (CPI3mo-lag ) and the index value with
a two-month lag (CPI2mo-lag ). Details of the calculations are shown
in Table 7.2, where the following equations are used
0. 125 151
= 0. 060887
2
155
d1
CPId = CPI3mo-lag +
(CPI2mo-lag CPI3mo-lag )
days in month
AI =
(7.1)
(7.2)
Putting it all together, the full invoice price to be paid on settlement

day is
105. 742333 = (103. 140625 + 0. 060887) 1. 02462
At this stage, it is helpful to introduce two key concepts and define
the real yield at time 0 for maturity T, ie, r = r(0, T ), and the market
expectation for inflation, or inflation break-even, ie, BE = BE(0, T ).
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Table 7.2 US CPI: all urban consumers, non-seasonally adjusted

Year
Jan
Feb
Mar
Apr
2011
220.223
221.309
223.467
224.906
Year
May
Jun
Jul
Aug
2011
225.964
225.722
225.922
226.545
Date
Days
in
month
3-month 2-month
lag
lag
d 1
Issuance 15 Apr 220.223 221.309

Settlement 13 Oct 225.922 226.545
14
12
Daily
Reference
Index
30
220.72980
31
226.16316
Index ratio
1.02462
Daily Reference Indexes and Index Ratio are rounded to five decimal
places.
Source: data from BLS, New Sky Capital, Credit Suisse.
According to the Fisher equation (Fisher 1930),7 their link to nominal

yield n = n(0, T ) is as follows
1 + n = (1 + r)(1 + BE)
Using this equation, we can write the net present value formula for
the price at time t of the inflation-linked bond P(t), with fixed coupon
C and a notional redemption floor struck at par
P(0) = (Q(0) + AI(0)) IR(0)
=
T

C IR(0)(1 + BE)k 100 IR(0)(1 + BE)T
+
+ Floor(0)
(1 + n)k
(1 + n)T
k =1
Note that we have written the index ratio in the future (ie, the inflation accretion on the linker notional) as the product of a known
inflation factor at t = 0, ie, the index ratio IR(0), and the future market expectation of inflation, ie, the break-even, over the remaining
life of the bond, eg
IR(k) = IR (0)(1 + BE)k
The deflation floor is struck at par, and its payout at maturity given
by
Floor(T ) = 100 max[1 IR(0)(1 + BE)T , 0]
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Since the market expectation for inflation, ie, the inflation break-even
(BE), simplifies on the numerator and denominator of the present
value equation, dividing by the known index ratio IR (0), we are
left with a formula that links the quoted price of the linker (Q) plus
accrued interest (AI) directly to real rates
Q + AI =
=
T

C(1 + BE)k 100(1 + BE)T
+
+ Floor (t)
k
T
(
1
+
n
)
(
1
+
n
)
k =1
T

(1 + r)k
k =1
100
(1 + r )T
+ Floor (t)
where the deflation floor has payout at maturity given by

Floor (T ) = 100 max[IR(0)1 (1 + BE)T , 0]
(7.3)
Neglecting the value of the floor for simplicity,8 the break-even can
be interpreted as the inflation rate that equalises the nominal yield
of the inflation-linked bond with the yield on the nominal bond.
In reality, the bond break-even is not just a pure measure of market
inflation expectations (which are more directly priced in the inflation
swap market covered later in the chapter), as it also contains a liquidity component, which can be material in newly established inflation
markets or during liquidity dislocations such as in autumn 2008.
In any case, this measure has become an important relative value
metric between the nominal and inflation-linked bond markets.
Going back to the linker cashflow formula, note that, since the
linkers coupon is generally smaller than the coupon on the nominal bond of comparable maturity and there is typically a positive
inflation accretion at maturity, the cashflows of the inflation bond
tend to be back-loaded relative to the nominal bond and, as a corollary, the linker exhibits higher rate duration than the nominal bond
of equal maturity (and thus higher credit risk as well). Regarding
duration, Equation 7.3 shows that inflation-linked bonds are sensitive to changes in real rates, while nominal bonds react to changes
in nominal rates (with real and nominal rates typically positively
correlated). Specifically, the duration of a linker, ie, the percentage
change in the full price of the linker for a 1% move in real rates, can
be written as (neglecting the floor)
D=
1 P
1
(Q + AI)
=
P r
Q + AI
r
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Thus, the linkers duration does not depend on the index ratio, as
the latter simplifies on both numerator and denominator. However,
the dollar change in the linkers price for a basis point move in real
rates (also called DV01) does depend on inflation accretion
DV01 = PD =
(Q + AI)
P
= IR
r
r
This formula shows how the DV01 of a linker is the balance of two
effects that occur over time: a decrease as we move closer to maturity (similar to what happens for nominal bonds) and possibly an
increase in the index ratio (ie, positive inflation accretion over time).
We can also define (real) rate convexity for linkers in a way that
mirrors nominal convexity for conventional bonds. Here, as before,
the index ratio simplifies in both numerator and denominator
C=
1 2P
1
2 (Q + AI)
=
P r2
Q + AI
r2
Finally, a few points on the carry (ie, coupon income minus financing costs) provided by linkers are worthy of mention. Initially, carry
is a function of the fixed coupon (typically lower than the coupon
on the nominal bond of similar maturity) and inflation accretion (ie,
the index ratio), which may partially offset the lower (relative to
nominal bonds) fixed coupon. Returning to the linker cashflow formula, since the latter is indexed to the non-seasonally adjusted CPI,
carry on linkers will not only move with the price index but also
mirror its seasonality fluctuations. Therefore, a (short-term) forecast
of inflation, including seasonal patterns,9 is necessary in order to
calculate carry and is often an important driver of relative value and
break-evens, especially for short maturity linkers.
In the following sections, we discuss how macroeconomic variables, such as real GDP, influence real rates and thus the price of
inflation-linked bonds, and we introduce the different approaches
used by market participants to analyse value in the sector. These
include both non-leveraged and leveraged investors. Typically,
while non-leveraged investors have a long-term horizon and are
mainly driven by the absolute level of real rates, leveraged investors,
who often act as liquidity providers, employ a complementary set
of value metrics and can have an important influence on the market
pricing in the short term. Realistically, most asset managers do end
up playing both roles when managing a linker portfolio, as they will
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Figure 7.1 Ten-year US TIPS real yield

2.0
1.5
1.0
0.5
0
1.0
6 Jan 2010
6 Feb 2010
6 Mar 2010
6 Apr 2010
6 May 2010
6 Jun 2010
6 Jul 2010
6 Aug 2010
6 Sep 2010
6 Oct 2010
6 Nov 2010
6 Dec 2010
6 Jan 2011
6 Feb 2011
6 Mar 2011
6 Apr 2011
6 May 2011
6 Jun 2011
6 Jul 2011
6 Aug 2011
6 Sep 2011
6 Oct 2011
0.5
Sources: Credit Suisse, New Sky Capital.
typically combine long-term positions with more tactical purchases.

In either case, understanding both the long-term views and shortterm tactical themes at play in the market is a crucial step for any
successful investment strategy.
Real rates: consumption, insurance benefit and economic
growth
When it comes to the inflation-linked bond market, the primary
focus of both domestic and international (non-leveraged) investors
is the level of real yields. In other words, the incentive to invest relies
on the premise that sacrificing consumption today will provide the
investor with the ability to consume more, in real terms, in the future.
Therefore, it is natural to compare real rates, as a market-determined
measure of investment growth, with other benchmarks of economic
growth.
The consumption argument provides a lower bound to real rates,
as it suggests that investors should not be willing to invest in
inflation-linked instruments when real rates in the market are negative, as this implies willingness to postpone consumption today in
exchange for less consumption tomorrow. This has generally been
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the case historically, although, at times (for example, in the wake

of the massive fiscal and monetary response to the 200811 financial crisis) real rates have traded negative for extensive periods.
When this happens, it is a sign that investors are driven not by the
promise of greater consumption in the future but by the insurance/
hedging benefit of investing in real rate products, albeit locking into
a (slightly) negative real rate in the process (see Figure 7.1 for an
example).
Real rates in the market influence not only the behaviour of
investors but also of borrowers, and in turn affect real economic
activity. For example, if real borrowing rates greatly exceed real production rates, a company, rather than investing in production, might
decide against financial leverage, which will force market real borrowing rates down. This is true even if the company takes on nominal
debt, as long as inflation affects the asset and liability side of its balance sheet to the same degree. Therefore, it is natural to compare the
effective real rates at which financing can be obtained by corporate
entities or the government10 with the rate of change in real GDP.
In general, different borrowers incur a different real cost of debt.
In particular, with the exception of the spike in sovereign credit risk
occuring at the time of writing,11 developed markets governments
have been able to achieve better credit ratings and lower borrowing costs (on both a nominal basis and a real basis) than domestic
private enterprises, whose output is generally a greater driver than
governments to overall GDP. However, credit spread considerations
aside,12 real rates should all be sensitive to real GDP growth, as the
relation between the two is a key input in decision making for all
economic agents involved (these include the government, private
corporations and individuals).
On these grounds, we can actually derive a long-term equilibrium value for real rates, based on macroeconomic arguments. In
particular, although real GDP growth will fluctuate along the business cycle, in the long term it should revert to its equilibrium value,
which is the potential GDP growth that is unique to each country.13
Although the latter should be interpreted as a dynamic equilibrium
level, in practice it is relatively stable, changing only gradually over
time. As a consequence, potential GDP growth provides an equilibrium level for real rates, as well as a simple value benchmark
against which investment opportunities in inflation-linked bonds
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Figure 7.2 Ten-year US TIPS real yields and real GDP growth
4.5
4.0
3.5
3.0
2.5
%
2.0
1.5
1.0
10-year real yield
0.5
Real GDP growth

Q4 2010
Q4 2009
Q4 2008
Q4 2007
Q4 2006
Q4 2005
Q4 2004
Q4 2003
Q4 2002
Q4 2001
Q4 2000
Q4 1999
Q4 1998
Q4 1997
Sources: Federal Reserve Bank of St Louis, New Sky Capital.
can be evaluated. In particular, although linker market prices can

decrease at times, real economic growth is a constraining factor, if
not a firm upper bound, for real rates. This of course cannot be said
of nominal bonds.
As a graphical illustration of this relation, Figure 7.2 shows historical real yields for the 10-year US TIPS versus real GDP growth (similar relationships can also be uncovered in other non-US inflation
markets).14
ASSET ALLOCATION WITH INVESTMENT-LINKED BONDS
Several studies have been done on asset allocation on portfolios that
include inflation-linked bonds among other competing traditional
asset classes. Most of these studies rely on the classic efficient frontier
approach (Markowitz 1952, 1959), where risk-adjusted returns are
estimated in nominal space.
The usual notes of caution for these asset allocation approaches
apply. First, their results tend to be quite sensitive to inputs, ie, asset
class returns, and volatilities and correlations in particular. The latter
are usually estimated from historical data, and might not be representative of returns distributions going forward. This is especially
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true when considering inflation risk, as the 1980s onwards saw a

steady decline of inflation rates and their volatility in developed
countries, which may or may not be what could be experienced in the
future. In any case, even if historical relations hold going forward,
such asset allocation frameworks are intrinsically for the long-term
investor, as short-term deviations can be material, especially in times
of market stress (as in the 200811 financial crisis). In addition, we
believe that, consistently with the consumption argument, it makes
sense to consider inflation risk explicitly, and thus translate these
approaches from nominal into real return space.
Specifically, consider the portfolio optimisation problem with n
asset classes in real return space (Perrucci 2011). Portfolio weights
and expected real returns are contained in the (n 1) column vectors
W and R, respectively, while is the (n n) real returns covariance
matrix. The vector R and the matrix are inputs (either estimated
from historical data or expressing investors views going forward);
the model output is the vector of asset class weights W, representing the optimal portfolio, ie, the portfolio satisfying the constraints
specified in the optimisation process. In addition to the usual constraints required to interpret W as a vector of weights (ie, weights
are non-negative and sum to 1), the investor might want to impose a
minimum portfolio real return, rmin , and a maximum portfolio real
volatility, max , ie
W T R = rmin
and W T W max
(the superscript T indicates the transpose). Mathematical machinery aside, it is interesting to analyse how an investor might use such
an allocation process in practice. As an example, consider a retail
investor who is engineering a financial plan to ensure a safe and
comfortable retirement. To this end, they will initially need to estimate and commit to a sustainable saving and investment schedule,
with the objective being to have enough proceeds later in life to satisfy their consumption needs. These needs also have to be estimated
and, as mentioned before, a consumption level should be targeted
in real rather than nominal terms, given the uncertainty on inflation.
Based on these projections, the investor can infer the minimum portfolio real return that is required, ie, rmin . Then, depending on their
risk and volatility tolerance, they can solve for the optimal portfolio.
Of course, there is a possibility that this optimal portfolio might not
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Figure 7.3 Cumulative real return for Barclays US Treasury and US

TIPS Indexes
200
US Treasury
180
US TIPS
160
140
autumn 2008
Flight to liquidity
120
100
Mar 2012
Mar 2011
Mar 2010
Mar 2009
Mar 2008
Mar 2007
Mar 2006
Mar 2005
Mar 2004
Mar 2003
Mar 2002
Mar 2001
Mar 2000
Mar 1999
Mar 1998
Mar 1997
80
Both indexes equal 100 at the beginning of March 1997.

Source: data from New Sky Capital, Barclays.
exist, in which case the investor will need to save more, bear more
risk or adjust their projected retirement lifestyle.
In essence, we propose to focus on liability matching in real terms,
ie, funding future retirement consumption, instead of a simple asset
allocation framework. The real return constraint provides a baseline
investment objective, and in effect ensures that the investor is taking the minimum level of risk compatible with funding future consumption. Of course, this does not prevent them from being more
aggressive if their risk tolerance allows.
Clearly, in a liability-matching framework in real return space,
inflation-linked bonds become the true risk-free asset, as their return
volatility is limited (see our previous discussion on the linkage with
real economic growth), and their cash proceeds are indexed to inflation. This is why they contribute to a better overall portfolio when
added into the mix with other asset classes. In addition, in contrast to
an investment in traditional asset classes such as equities and nominal bonds, their real return profile is intrinsically more stable and is
not dependent on inflation forecasts, and thus their model outputs
are less sensitive to biases in historical estimates or regime shifts in
inflation going forward.
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Table 7.3 Summary statistics for monthly returns

Monthly
real
returns

Average (%)
Standard deviation
Correlation
Number of observations
Monthly
nominal
returns

US
Treasury
US
TIPS
US
Treasury
US
TIPS
0.31
1.49
0.36
1.72
0.51
1.36
0.56
1.72
66
175
64
175
As an illustration, Figure 7.3 shows the cumulative returns of

Barclays US Treasury and US TIPS Indexes in inflation-adjusted
(real) terms. Despite the flight to liquidity in autumn 2008, where
nominal treasuries dramatically outperformed, the inflation-linked
index cumulative return is 88.9% in real terms, versus 72.9% for the
nominal index.15
Using (continuously compounded) monthly return data, we have
also derived some summary statistics (Table 7.3) for both inflationadjusted and nominal returns.
Finally, the efficient frontiers in real and nominal space are plotted
in parts (a) and (b) of Figure 7.4, respectively. Note that the optimal
portfolio blend depends on whether the exercise is conducted in
real or nominal space, with 50% of portfolio allocated to TIPS in the
former case and only 30% in the latter.16 These results suggest that
calculating optimal portfolios using nominal returns (as is routinely
done, contrary to the approach suggested in this chapter) would tend
to underestimate the target allocation to inflation-linked securities.
PRICING DISTORTIONS AND OPPORTUNITIES IN
INFLATION-LINKED BONDS
Inflation-linked bonds trade in both the primary and secondary markets. The primary market is where inflation-linked securities are
issued and sold to investors, most of whom are non-leveraged, with
a medium- to long-term investment horizon. The primary market
is a major mechanism through which global capital imbalances are
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Figure 7.4 Efficient frontier and optimal portfolio results
Annualised real return (%)
4.4
(a)
100% TIPS portfolio
4.3
4.2
4.1
Optimal blend: 50% Treasury and 50% TIPS portfolio
4.0
3.9
3.8
100% Treasury portfolio
3.7
4.8
Annualised nominal return (%)
6.8
5.0
5.2
5.4
5.6
5.8
Annualised volatility of real returns (%)
(b)
6.0
100% TIPS portfolio
6.7
6.6
6.5
6.4
Optimal blend: 70% Treasury and 30% TIPS portfolio
6.3
6.2
100% Treasury portfolio
6.1
4.4
4.6
4.8
5.0
5.2
5.4
5.6
Annualised volatility of nominal returns (%)
5.8
6.0
Results for (a) real return space; (b) nominal return space.
corrected and capital surpluses from savers and investors are put to
use by producers and issuers, respectively.
A secondary market is also active, and this is where investors
can rebalance and adjust their portfolios and issuers can get price
indications for where the market is trading. In the secondary market for inflation-linked bonds, liquidity is relatively good, albeit
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3.0
1.5
3.0
0.5
i
18 Oct 2010
1 Nov 2010
15 Nov 2010
29 Nov 2010
13 Dec 2010
27 Dec 2010
10 Jan 2011
24 Jan 2011
2 Feb 2011
21 Feb 2011
7 Mar 2011
21 Mar 2011
4 Apr 2011
18 Apr 2011
2 May 2011
16 May 2011
30 May 2011
13 Jun 2011
27 Jun 2011
11 Jul 2011
25 Jul 2011
8 Aug 2011
22 Aug 2011
5 Sep 2011
19 Sep 2011
3 Oct 2011
18 Oct 2010
1 Nov 2010
15 Nov 2010
29 Nov 2010
13 Dec 2010
27 Dec 2010
10 Jan 2011
24 Jan 2011
2 Feb 2011
21 Feb 2011
7 Mar 2011
21 Mar 2011
4 Apr 2011
18 Apr 2011
2 May 2011
16 May 2011
30 May 2011
13 Jun 2011
27 Jun 2011
11 Jul 2011
25 Jul 2011
8 Aug 2011
22 Aug 2011
5 Sep 2011
19 Sep 2011
3 Oct 2011
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(a)
2.5
(b)
2.5
Figure 7.5 Real yield and inflation break-evens for selected US TIPS
TII Q5 Apr 15 real
TII Q5 Apr 15 BE
2.0
1.5
%
1.0
1.5
0.5
1.0
TII 1.125 Jul 20 real
TII 1.125 Jul 20 BE
2.0
%
1.5
1.0
0.5
(a) Five-year time horizon; (b) ten-year time horizon.

Source: data from Credit Suisse, New Sky Capital.
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Figure 7.5 (Continued )

3.0
(c)
2.5
2.0
% 1.5
1.0
TII 1.125 Feb 40 real
1.5
TII 1.125 Feb 40 BE

18 Oct 2010
1 Nov 2010
15 Nov 2010
29 Nov 2010
13 Dec 2010
27 Dec 2010
10 Jan 2011
24 Jan 2011
2 Feb 2011
21 Feb 2011
7 Mar 2011
21 Mar 2011
4 Apr 2011
18 Apr 2011
2 May 2011
16 May 2011
30 May 2011
13 Jun 2011
27 Jun 2011
11 Jul 2011
25 Jul 2011
8 Aug 2011
22 Aug 2011
5 Sep 2011
19 Sep 2011
3 Oct 2011
(c) Thirty-year time horizon.

Source: data from Credit Suisse, New Sky Capital.
not nearly as good as in other larger asset classes, such as nominal government bonds. This opens the way for temporary price
dislocations, and thus opportunistic plays, where providing liquidity at the right time is greatly rewarded. Because of the very nature
of these opportunities, most liquidity providers are sophisticated
leveraged investors, such as banks proprietary desks and hedge
fund managers, who have their finger on the pulse of technical
flows, and can quickly position accordingly. Although their time
horizon can vary, it is usually short to medium term (typically a
few days or weeks), and thus complements other investors, such
as traditional asset managers, who tend to have a more fundamental long-term approach. Furthermore, while several non-leveraged
investors have a long-only bias (investing in real rates), these liquidity providers take positions on both the long and short sides of the
market, thus betting on either real rates or inflation break-evens.17
Because of the diversity in investors objectives, time horizons and
valuation approaches, the market might be pricing certain securities
or market variables efficiently, while at the same time pricing others
inefficiently.
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And this is precisely where opportunities come about (Perrucci

2010). Specifically, some common price dislocations in the inflationlinked bond market arise from the following:
(i) market pricing driven by real rates levels versus inflation
break-evens;
(ii) lack of index sponsorship at the very front end of the curve;
(iii) liquidity driven issue-specific opportunities;
(iv) new issue auctions and month-end index rebalancing; and
(v) risk-adjusted inflation break-even rates.
We shall analyse these one by one in the following.
Market pricing driven by real rates levels versus inflation
break-evens
As mentioned above, two important factors driving the pricing
of long maturity inflation bonds (ie, of the long-end of the real
yield curve, 10-year maturity or longer) are demand from long-only
liability-matching investors and equilibrium growth rates for the
real economy (as measured, for example, by potential GDP growth).
In other words, for long tenors (ie, a long time to maturity), the price
of inflation-linked bonds will be most sensitive to the level of real
rates, reflecting how most market participants in the long-end of the
curve evaluate investments in the space.
The mix of investors is quite different for short-maturity inflationlinked bonds, ie, for the short end of the real yield curve (fiveyear maturity or shorter). Over short time horizons, inflation rates
(and monetary policy actions) are somewhat more predictable, and
many investors look at relative value between nominal and inflationlinked bonds. In this regard, it is inflation break-evens that matter,
and an investor might be willing to buy an inflation-linked bond
even if real rates are very low, if they can pair the trade by selling
the comparable maturity nominal bond. In other words, if inflation
break-evens are attractive, it makes sense to buy a rich inflationlinked bond if it is possible to sell an even richer nominal bond at
the same time. These relative value comparisons, rather than the
absolute level of real yields, drive market pricing in the short end of
the real curve.
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Intermediate maturities along the curve are less clean-cut, with

market pricing being driven by rate levels at some times and inflation break-evens at others. Naturally, the prevailing mix of forces in
the market also varies with time, with different investors providing
pricing dislocations and opportunities for each other.
Lack of investment index sponsorship at the very front end of
the curve
At the very front end of the real yield curve, rates often display
technical price distortions. These are mainly due to the fact that most
inflation-linked bond indexes exclude securities with maturities of
one year or less, so that there are fewer natural holders of these
bonds. As a consequence, the latter tend to trade at a discount to
fundamental value, which at very short maturities can be assessed
by combining near-term inflation and monetary policy outlooks, or
at a discount to other parts of the curve.
Liquidity driven issue-specific opportunities
Although the US TIPS market is large (Table 7.1), it is only a fraction
of the total US Government debt, in terms of both size and daily trading volumes. As a result, transaction costs and bidask spreads are
typically higher than those on comparable nominal bonds. Indeed,
the US TIPS market has displayed a persistent liquidity risk premium, with average bidask spreads of the order of 510 basis points
(bp) around the quoted real yield.
These transaction costs can be material, especially for long duration bonds: for example, a 10bp bidask spread on a ten-year US TIPS
(assuming an eight-year duration for illustration sake), amounts to
about 26 ticks (1/32 of a point). In addition, even within the linker
market, certain bonds have better liquidity than others, for example,
on-the-run (ie, the security most recently issued) versus off-the-run
securities (older issues).
Because a large share of the market is owned by managers who
passively invest in the index, and whose investment guidelines limit
the number and type of linkers they can actually trade, these liquidity distortions can be magnified for certain specific issues, especially
when indexed managers are forced to transact large amounts in relatively illiquid bonds. Given the size of the bidask spread, there is
clearly scope for the active manager (who provides liquidity for the
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right issue and at the right time) to add value to an active portfolio
by just achieving superior execution.
Other inefficiencies: market-on-close prices, new issue
auctions and index rebalancing
The influence of passive-indexed-investors in the US TIPS market
also creates other opportunities. To start, as benchmarks use marketon-close prices to calculate returns, many passive investors tend to
trade at, or near to, market close to better track their index. Indeed, it
is not uncommon to see the market richen near closing time (by half a
point or even more) purely owing to this technical effect, and to then
cheapen again the following day. This structural pattern has been
consistent over time, and offers opportunity for the active investor
to buy cheap bonds intra-day and sell them rich near the close of the
trading session.
In addition, new issue auctions and month-end rebalancing are
two calendar events that typically have a material technical effect on
the market. For example, it is not unusual for US TIPS to cheapen in
the weeks ahead of auction dates (there are eight US TIPS auctions
each year) in anticipation of supply, and then richening again in the
weeks following, as many passive investors are obliged to buy newly
issued benchmark-eligible securities. A similar mechanism is at play
when the benchmark index is rebalanced at the end of each month.
Although the specific issues that will be leaving or joining the index
are known in advance, passive investors, wishing to closely match
their benchmark price performance, tend to rebalance their portfolio
only close to the end of the month. This offers a structural mechanism
to add value for active managers who can anticipate buying/selling
activity and position accordingly.
Risk-adjusted inflation break-even rate
In most market conditions, inflation-linked bonds have lower price
volatility than the nominal bonds of similar maturities. This is
because, despite the fact that linkers have higher interest rate duration, real yields tend to be less volatile than nominal yields.18 This
implies that risk-constrained investors can hold a higher notional of
inflation-linked bonds than of notional bonds. Therefore, if we were
to compute the inflation break-even rate between a real bond and a
smaller risk-adjusted notional of the equal maturity nominal bond,
the result would be a risk-adjusted break-even rate smaller than the
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typical inflation break-even measure, which assumes equal notional

for both securities. Specifically, if we assume that n is the nominal
rate, r is the real rate and BE is the inflation break-even, p < 1 is the
ratio between the volatility of the linker and the nominal bond and
the linker can be financed at rrepo < n, then19
pn = r + BE (1 p)rrepo
or
BE = pn + (1 p)rrepo r < n r
To conclude, because different investors have their own unique
definition of the inflation break-even rate, it can differ from the
most commonly used break-even measure, which is basically the
difference between the nominal and the real rate.
NON-GOVERNMENT INFLATION-LINKED BONDS
Over the years, many corporations and local municipalities, with
either revenues linked to inflation or real assets on their balance sheet, have issued inflation-linked debt. Issuers include infrastructure, real estate, toll-road and utilities companies. Assetliability management and attractive financing (ie, low real yields even
once a credit spread is included) resulting from the strong demand
for such assets by pension funds and insurance companies are two
major drivers for non-government issuers of inflation-linked bonds.
A corporation can match inflation-linked revenues with funding
by either issuing inflation-linked debt directly or issuing nominal
debt and pay inflation (while receiving a fixed rate) in an inflation swap (we shall discuss inflation swaps in the next section).
Historically, the latter option has often been the more attractive, as
inflation swaps have typically traded rich to cash, given the strong
demand for non-capital-intensive inflation indexation from pension
funds in particular. However, besides the economics of the transaction, accounting rules (specific to each country of issuance, especially in regard to the swap) also influence the choice of one funding
alternative over the other (Figure 7.6).
Note, however, that the issuance of inflation-linked debt does not
always result in a net supply of inflation-linked cashflows to the market. In fact, several non-government entities have issued inflationlinked debt while receiving inflation in a swap at the same time (Figure 7.7). This might seem odd, given the typical richness in inflation
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Figure 7.6 Non-government supply of inflation-linked cashflows

(a)
Inflation-linked revenues
Corporate
issuer
Inflation-linked bond
Corporate
issuer
Nominal bond
Inflation-linked revenues
Pay inflation
in a swap
Receive fixed
(b)
Inflation swap
(a) Issuing an inflation-linked bond. (b) Issuing a nominal bond and paying inflation
in a swap.
Figure 7.7 Inflation-linked issuance with no net supply of

inflation-linked cashflows
Inflation-linked bond
Pay fixed
in a swap
Receive inflation
Corporate
issuer
Inflation swap
swaps at which we hinted earlier. However, this type of issuance

has flourished as a result of strong demand for specific inflation
structures from pension funds and retail investors in particular. In
these swapped inflation-linked notes, coupons are typically linked
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to the year-over-year inflation rate (floored at zero), thus avoiding

the unfavourable tax treatment of sovereign-style linkers, where the
principal accretion is taxed immediately but payment is received
only at maturity. Not surprisingly, the issuance of these inflationlinked structures has been one of the main drivers in the development and increasing liquidity of the year-over-year swap and option
markets.
In addition, although inflation exposure can be obtained in several
ways by combining cash bonds and/or derivatives, many investors
are typically restricted by investment guidelines to only a subset of
these instruments (in particular, some may not be allowed to short
nominal bonds or enter derivative contracts). For the latter, investing
in a non-government inflation-linked note might be the only way
to combine inflation indexation with a credit risk premium and/or
the tax benefits of a municipal bond, as replicating indexation with
a cash break-even strategy or an inflation swap is not a viable or
practical option.
INFLATION DERIVATIVES WITH LINEAR PAYOUTS
Over time, along with the inflation bond market, a global inflation derivatives market has also developed. In fact, derivatives with
either linear (ie, futures and swaps) or non-linear (ie, options and
more complex exotic structures) payouts are traded every day, albeit
with different degrees of liquidity. These instruments are less capital intensive than cash bonds, and can be tailored to the needs of
investors to a greater degree.
In this section, we shall limit our analysis to linear derivatives, and
swaps in particular, given that volume and liquidity of exchangetraded inflation futures are both quite limited. Inflation swaps play
an important role in many inflation markets, especially in the Eurozone and the UK, and to a lesser degree in the US. Several structures
(zero-coupon swap, year-over-year swap, linker asset swap, multiplicative swap, additive swap, total rate of return swap, etc) with a
similar underlying theme are traded, ie, the exchange of inflationlinked cashflows for fixed rate or variable (based on the London
Interbank Offered Rate (Libor)) payments.
Natural payers of inflation-linked cashflows include corporations
with inflation-linked revenues (this case is illustrated schematically in Figure 7.6(b)) and asset-swap buyers (a case that we will
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Figure 7.8 Zero-coupon inflation swap
Inflation
Inflation
payer
Inflation
receiver
Fixed rate K %
At maturity the inflation payer pays notional (index(T )/index(base) 1) and the
index receiver pays notional ((1 + K%)T 1).
Figure 7.9 Additive year-over-year inflation swap
R % + inflation
Inflation
payer
Inflation
receiver
Libor (quarterly)
Each year Y the inflation player pays notional (R% + max[index(Y )/index(Y
1) 1, 0]). The inflation receiver pays quarterly notional Libor day count.
Figure 7.10 Multiplicative inflation swap
Inflation linked
Inflation
payer
Inflation
receiver
Libor (quarterly)
The inflation payer pays semi-annually a fixed rate R% on an inflation-accreting

notional day count. At maturity the cumulative inflation accretion (floor may
apply) is also paid. The inflation receiver pays quarterly a notional Libor day
count.
discuss in the next section). Receivers of inflation include several

investors, such as insurance companies and pension funds wishing
to hedge their liabilities, and retail investors. Corporate entities that
issue swapped inflation-linked debt (a case shown in Figure 7.7) are
also on the receiver side of inflation. It is fair to say that demand
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for off-balance-sheet inflation exposure (ie, for receiving inflationlinked cashflows in a swap) has often, albeit not always, outstripped
supply, resulting in a premium offered to inflation payers relative to
the cash market (we hinted as to this effect when comparing parts
(a) and (b) of Figure 7.6).
The simplest and most liquid inflation swap is the zero-coupon
swap, with only one cashflow exchanged at maturity. Specifically, at
maturity T, the inflation payer will pay the realised inflation over
the life of the contract, in exchange for a previously agreed fixed rate
K%. This is shown schematically in Figure 7.8.
In each market, the price index underlying the swap is typically
the same as the corresponding bond market (eg, CPI (all urban consumers, non-seasonally adjusted) for the US), while rules for the
calculation of the relevant daily price index, in particular the length
of the lag and whether or not interpolation is used, can vary quite a
lot.20 As for settlement, the inflation swap market typically follows
nominal swap market conventions (eg, t + 2 in the US and EU, t+ in
the UK), and thus usually differs from the bond market.
On each trading day, zero-coupon inflation swap quotes for
annual tenors (typically up to 10 years, although sparser quotes
often extend to longer maturities) are readily available (for example, on Bloomberg and other brokers screens). From these inflation
swap quotes, it is straightforward to derive a discrete (annual intervals) curve of forward index price levels and implied inflation rates.
To construct a continuous (in this context, monthly) curve,21 two
additional tools are required:
a method for interpolation (linear, cubic spline, etc) between
the annual tenors; and

monthly adjustments for seasonality.
The inflation swap curve thus derived provides the base from which
all other more complex swaps can be priced.
Another common swap is the additive, or year-over-year, inflation swap. In this structure, one party pays a fixed coupon plus
inflation (typically floored at zero) annually in exchange for fixed or
variable (Libor) rate payments. As mentioned in the previous section, this structure (Figure 7.7) has developed to match similarly
additive corporate inflation-linked notes issuance (common in the
European retail market in particular), where there is no accretion on
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notional, but inflation is carried by the coupon, thus allowing for a

more favourable tax treatment. An example of year-over-year swap
is shown in Figure 7.9.
The multiplicative (also known as accreting or bond-style)
swap is meant to exactly mirror the inflation cashflows of linkers
with accreting notional (eg, government linkers like US TIPS). In
this structure, one party pays a fixed coupon (semi-annually) on a
notional that is linked to inflation, in exchange for fixed or variable
(Libor) rate payments. If there is a deflation floor in the inflationlinked bond (as in the US market), the inflation accretion corresponding to the notional payment at maturity is typically also floored at
zero. Multiplicative swaps are those used in inflation asset-swap
transactions discussed in the next section. An example is shown in
Figure 7.10.
ASSET SWAPS AND INFLATION ASSET SWAPS
The asset swap (ASW) a is transaction where the ASW buyer goes
long an underlying bond, and swaps the bond cashflows for Libor
plus a spread (the ASW spread)22 . Any bond can be used in an ASW
transaction (nominal, inflation-linked, government or corporate
credit bond, etc). A generic example is shown in Figure 7.11.
Through this transaction, the ASW buyer has effectively transformed the underlying bond into a synthetic Libor floater (plus a
spread),23 while the ASW seller has secured off-balance-sheet termfinancing of the underlying asset at a cost of Libor plus the ASW
spread. The ASW buyer bears the default risk from both the underlying bond and swap counterparty, and the market risk from changes
in the spread between the curve used to discount the bond cashflows (driven by interest rate, credit or liquidity factors) and the
swap curve (Table 7.4). An ASW is, at the core, a financing transaction, where the buyer retains the credit24 and liquidity component of
the underlying asset (columns (c) and (d) in Table 7.4), while transferring interest rate risk (column (a) plus column (b))25 (and inflation
risk for linkers; see column (e) in Table 7.5) to the ASW seller.
Among the several flavours of ASW traded, the most common are
the proceeds ASW (ASWproceeds ) and the parpar ASW (ASWparpar ).
In a proceeds ASW, the swap notional is set equal to the dirty price
of the underlying bond. This is a natural choice, given that the dirty
price of the asset is the amount to be financed through the swap
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Figure 7.11 Generic bond asset swap
Bond
Bond cashflows
ASW
buyer
Bond cashflows
ASW
seller
Libor + ASW spread

The ASW buyer buys the bond and pays bond cashflows and receives Libor plus
ASW spread in the swap. The ASW seller receives the bond cashflows and pays
Libor plus ASW spread in the swap.
Table 7.4 The effect of interest rate and spread changes

Interest rate

Market value of
bond and swap
ASW buyer
Bond
Pay bond cashflows
Receive Libor + AWS
ASW seller
Pay Libor + AWS
Receive bond cashflows
Parpar ASW
Proceeds ASW
Zero volatility spread
Spread

Tsy yield Swap yield Liquidity Credit

up
up
up
up
(a)
(b)
(c)
(d)
Down
N/A
N/A
N/A
Up
Down
N/A
N/A
Down
N/A
N/A
N/A
N/A
Down
N/A
N/A
N/A
N/A
Up
Up
Up
Down
Down
Down
Up
Up
Up
Up
Up
Up
Slightly
down because of the small duration from the ASW fixed spread.
up because of the small duration from the ASW fixed spread.
The market movements shown are essentially partial derivatives. The four
variables are the nominal Treasury yield corresponding to the bond maturity, the swap yield for the same maturity, the bond liquidity spread and the
bond credit spread. For example, in column (a) the Treasury yield goes
up, while the other three variables are fixed (unchanged swap yield means
that the swap spread narrows). In column (b), the swap yield goes up, but
the Treasury yield, the bond liquidity spread and the bond credit spread
are unchanged.
Slightly
transaction. However, ASWs are at times executed and quoted on a

parpar basis, meaning that the swap notional is set equal to the bond
notional rather than its dirty price. This means that for premium
(discount) bonds the ASW seller is effectively financing a smaller
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Figure 7.12 US TIPS asset swap
US
TIPS
US TIPS cashflows
ASW
buyer
US TIPS cashflows
ASW
seller
Libor + ASW spread
(greater) amount than the price of the bond, so will have to pay
the premium to (or receive the discount from) the ASW buyer up
front. In either case, the ASW spread can be determined by setting
the net present value of the swap cashflows equal to zero, but the
specific formulas, and the resulting ASW spreads, differ depending
on whether the swap is quoted on a proceeds or parpar format.
As an example, suppose that the bond has a full (dirty) price P,
pays annual coupons equal to Cj and has redemption amount B at
maturity T; i is the swap curve discounting factor for maturity ti
(ie, the present value of a US dollar paid at time ti ); li is the Libor
paid semi-annually at time ti (and set at time ti1/2 ); i is the day
count to be applied to floating-rate payments at time ti . Then, for a
proceeds ASW, where the swap notional is equal to the bond dirty
price P, the ASW spread calculated as
2T
T

P
i/2 i/2 (li/2 + ASWproceeds ) + (P B)T
j Cj = 0

100 k =1
j =1

notional exchange
Libor cashflows
bond coupons
In comparison, for a parpar ASW, where the swap notional is equal

to par and there is an additional upfront cashflow exchange, the
ASW spread calculated as
(P 100) +

upfront exchange
2T

i/2 i/2 (li/2 + ASWparpar )
k =1
+ (100 B)T
T

j C j = 0
j=1
By using the fact that a Libor floater is worth par, ie

2T

i/2 i/2 li/2 + 100T = 100
k =1
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we can derive the following

T
ASWproceeds =
ASWparpar =
j=1 j Cj + BT P
2T
1
k=1 i/2 i/2
100 P
P
ASWproceeds
100
from which we can see that the net present value of the ASWproceeds
spread payments compensates for the difference arising from discounting the bond cashflows using the swap curve versus the relevant bond curve. Also, note that the parpar and proceeds ASW
spreads are the same only for bonds trading at par. Therefore, it is
not straightforward to compare bonds using ASW spreads, and the
zero volatility spread (ZV), which is the continuously compounded
spread on top of swap rates needed to recover the price of the bond,
is often used instead
P = BT exp( ZV tT ) +
T

j Cj exp( ZV tj ) = 0
j =1
When the asset underlying the swap is an inflation-linked bond (Figure 7.12 for an example depicting US TIPS as the underlying asset
bond), the analysis is complicated by the fact that we need to project
nominal inflation-linked payments into the future.
To this end, inflation index values implied by zero-coupon swaps
are used to project notional accretion on the inflation-linked bonds,
ie, the index factor ratios IR(J ), from trade date to maturity. One
can then use the formulas derived above simply by explicitly introducing index factors and the inflation floor at maturity. Specifically
(assuming the day count factor for the annual coupon payment is 1
for simplicity of notation)
CJ = C IR (J ),
B = 100 max[IR(T ), 1]
It is interesting to reproduce a table similar to Table 7.4 but with the

inclusion of all market factors relevant in an inflation asset swap.
In particular, the underlying assets (ie, the inflation-linked bonds)
market price depends on the real yield (and possibly also a credit
spread), which is approximately equal to the nominal Treasury yield
minus the cash inflation break-even (Fishers equation). However,
as mentioned before, the government-linker inflation break-even
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Table 7.5 The effect of interest rate, spread and inflation break-even
changes
Interest rate

Market value of
bond and swap
ASW buyer
Inflation-linker
Spread
Inflation

Tsy Swap
swap
yield yield Liquidity Credit
BE
up
up
up
up
up
(a)
(b)
(c)
(d)
(e)
Down
N/A
Down
Down
Up
Pay linker
cashflows
N/A
Up
N/A
N/A
Down
Receive Libor + AWS
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
Receive linker
cashflows
N/A
Down
N/A
N/A
Up
Parpar ASW
Up
Down
Up
Up
No
change
Proceeds ASW
Up
Down
Up
Up
No
change
Zero volatility spread
Up
Down
Up
Up
Down
ASW seller
Pay Libor + AWS
Slightly
down because of the small duration from the ASW fixed spread.
up because of the small duration from the ASW fixed spread.
The sensitivities shown are essentially partial derivatives, where one variable is moved and the remaining four are held fixed. For example, in column
(a) the Treasury nominal yield goes up, but the inflation break-even does
not move, and so the other spreads and thus the linker price go down (in
other words, the real yield moves in lockstep with the nominal yield, thus
driving down the linker price). In column (e), the inflation break-even goes
up, but the nominal Treasury yield is held fixed, implying that the real yield
goes down, thus increasing the price of the linker. The ASW spread does
not change with a change in inflation break-even, as the swap fixed-leg
change in market value is picked up either by the upfront payment (in a
parpar swap) or by a change in swap notional (for a proceeds swap).
Slightly
typically also contains a liquidity component, and market inflation expectations are better measured by zero-coupon (ZC) swap
inflation break-evens. Convexity considerations aside (the cash inflation break-even on a coupon bond will be different from a ZC swap
break-even even in the absence of a bond liquidity premium), we
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can write
real yield r n BEcash
n BEswap + liquidity spread
Therefore, in Table 7.5, our market risk factors are:

(a) the nominal Treasury yield n;
(b) the swap yield;
(c) a bond liquidity spread;
(d) a bond credit spread; and
(e) the zero-coupon swap inflation break-even BEswap .
Note that the ASW spread is a liquidity and credit spread. In particular, it does not depend on the inflation break-even, or on interest rates
(assuming that both nominal Treasury yields and swap yields move
in lockstep, the ASW spreads do not change, ie, (a) + (b) cancel out).
In comparison, the ZV also depends on the inflation break-even.
The fact that linker ASW levels depend not only on the credit but
also on the liquidity spread has become a major driver of linker ASW
trades. Essentially, demand is generally strong because these swaps
provide inflation-linked payments with the extra accounting benefit of off-balance-sheet treatment. As a consequence, linker ASWs
often trade more cheaply than their nominal counterparties with
the same credit risk. This has attracted into the sector many holdto-maturity buyers, who have become inflation-swap payers to take
advantage of the supplydemand imbalance. It is very common for
insurance companies to buy linker ASWs rather than nominal ASWs,
to lock-in (receive) a higher fixed or floating rate against their own
liabilities without exposing the firm to any additional credit risk
exposure.
CONCLUSIONS
The inflation-linked cash and derivatives markets have developed
globally, providing an attractive set of investment opportunities to
a variety of market participants, including asset managers, retail
investors, pension funds and central banks. In this chapter, we
covered inflation-linked bonds and linear inflation derivatives.
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Inflation-linked bonds are designed to compensate investors for

the loss in purchasing power caused by changes in overall price levels. To this end, coupon and principal payments are linked to an
inflation index. Both developed and emerging market government
and non-government entities have issued inflation-linked bonds,
although the level of activity and liquidity varies for each local
market. We discussed how macroeconomic variables, such as real
GDP, influence real rates and thus the price of inflation-linked
bonds, and also introduced the different approaches used by market
participants to analyse value in the sector.
Over time, along with the inflation bond market, a global inflation derivatives market has also developed. Derivatives with either
linear or non-linear payouts are traded every day, albeit with different degrees of liquidity. These instruments are less capital intensive
than cash bonds and can be tailored to the needs of investors to a
greater degree. We discussed the most common swap structures and
concluded with an in-depth analysis of inflation asset swaps and the
effect of market factors moves on valuations and quoted spreads.
1
Obviously, we are referring to the modern inflation-linked market. Historically, the indexation
of government debt has deeper roots that can be traced back to bills linked to the price of
silver issued by the Massachusetts Bay Colony in 1742.
Note that EU countries have at times issued linkers indexed to either their domestic inflation
index or the Euro Harmonized Index of Consumer Prices (HICP).
There has been mixed empirical evidence on the inflation risk premium, as often the liquidity premium between nominal and inflation-linked bonds acts in the opposite direction,
especially in newly established markets. However, it is plausible that a positive inflation risk
premium exists more often than not in liquid markets, especially for long tenors, where the
insurance benefit is more important.
The CPI released in month n is released about two weeks into the following month.
However, real rates themselves are correlated to inflation.
The quoted price is expressed as an integer (103) plus ticks (4, one tick being 1/32) and half a
tick (+ = 1/64). Therefore, 103 4+ translates into 103 + (4/32) + (0.5/32) = 103.140625.
Fishers equation neglects the risk premium, which is a function of the correlation between
real rates and inflation.
This is often, but not always (contrast with what happened in 20089) a reasonable approximation for long-maturity linkers or for when the floor is far out-of-the-money (old versus
new issue linkers). Alternatively, option-adjusted break-even measures can be developed by
accounting for the value of the deflation floor explicitly.
However, the market has become increasingly efficient when it comes to pricing seasonality.
10 As most corporates do not issue inflation bonds, this will be a nominal rate adjusted by ex
ante expected inflation, or ex post realised inflation rate.
11 The Greek debt crisis started in 2009 and is ongoing at the time of writing; this affected other
developed market countries in Europe and elsewhere (eg, US, Japan, Spain, Ireland, Portugal,
Italy, UK) with unsustainably high levels of debt.
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12 Note that governments have traditionally been considered more creditworthy than domestic
companies, at least on debt denominated in local currency, because of the ability to print
money, thus inflating debt away and devaluing the currency. This may no longer be the case
for the Eurozone countries, which have forgone this option by adopting a common currency.
13 Potential GDP growth is not directly observable, but estimates can be derived by empirical
study of equilibrium relations as well as macroeconomic considerations.
14 To analyse the link between real rates and economic growth, New Sky Capital uses a proprietary blend of realised and potential GDP (as published by the US Federal Reserve; see
http://research.stlouisfed.org).
15 Note that the Barclays US Treasury Index duration is smaller (about five years on average)
than the Barclays US TIPS Index duration (about eight years on average). It is also plausible
that some of the outperformance of US TIPS over nominal Treasuries might be due to a
progressive narrowing of the liquidity/novelty premium on inflation-linked bonds.
16 Here and in the figures, by optimal portfolio we mean the portfolio with highest expected
return per unit risk.
17 This being said, many long-only money managers also look at inflation-linked bonds as a
substitute to nominal government securities in their benchmarks. Thus, these investors also
express an implicit view on break-evens.
18 This is a consequence of the positive correlation between real rates, nominal rates and inflation. Typically, in a bond rally (sell-off), both real rates and market inflation expectations will
decrease (increase); thus, nominal rates will generally be more volatile than real rates (exceptions occur, especially at the front end of the real curve, which is more sensitive to inflation
surprises).
19 Differences in haircuts and repo rates between nominal bonds and linkers (usually more
vexing for the latter) are second-order effects for the purpose of this calculation.
20 For the US swap market the lag and interpolation formula are the same as those used for US
TIPS, but for the UK and Eurozone swap market there is a lag but no daily interpolation in
the swap reference price index.
21 Special care and additional instruments such as inflation futures are typically used to construct
the short end of the curve (with tenor less than one year), but a discussion is beyond the scope
of this section. Note that inflation price index seasonality translates into greater amplitude
of seasonality for inflation swap rates in short versus long tenors (as the same price index
seasonality is damped in long-term swap rates).
22 This spread can be positive or negative (depending on the relative credit and liquidity risks
of the underlying bond and the swap market).
23 A synthetic floater is one obtained by combining several underlying transactions, whose
cashflows effectively combine.
24 In addition, both ASW parties assume counterparty credit risk.
25 What is meant here is that if both Treasury yield and swap yield move in lockstep, the market
value change in the bond and the fixed leg of swap offset. Technically, there is a residual
interest rate risk resulting from different discounting curve on the asset (bond) and swap side
(ie, different durations even if all discounting curves involved move in parallel).
REFERENCES
Bnaben, B., 2005, Inflation-Linked Products (London: Risk Books).

Bnaben, B., and S. Goldenberg, 2008, Inflation Risks and Products (London: Risk Books).
Fisher, I., 1930, The Theory of Interest: As Determined by Impatience to Spend Income and
Opportunity to Invest It (Philadelphia, PA: Porcupine Press, Reprint, 1977).
Markowitz, H., 1952, Portfolio Selection, The Journal of Finance 7(1), pp. 7791.
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Markowitz, H., 1959, Portfolio Selection: Efficient Diversification of Investments (New York:
John Wiley & Sons).
Perrucci, S., 2010, Inflation-Sensitive Assets: Portfolio Benefits and Opportunities,
Report, URL: http://www.newskycapital.com.
Perrucci, S., 2011 Efficient Frontier and Optimal Portfolios in Real vs. Nominal Space,
Report, URL: http://www.newskycapital.com.
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Understanding and Trading Inflation

Swaps and Options
Brice Bnaben; Herv Cros; Franck Triolaire

New Sky Capital; BNP Paribas; Morgan Stanley
Inflation is certainly one of the most watched, analysed and, to some

extent, feared economic phenomena. One of the reasons is its widespread impact on every individual, company and country, albeit
different economic players have different sensitivities to inflation.
Specifically, some economic agents, such as pension funds and
insurance companies, are concerned by the possibility of an unexpected rise in inflation, which would require higher cashflows to
service their benefits payable, the latter often fixed in real terms. In
contrast, other economic agents, such as utility and infrastructure
financing companies, and to some extent central and local governments, have revenues correlated to inflation, and therefore are more
concerned by unexpected disinflation or deflation, which negatively
impact on the nominal amount of cashflow receivables.
The recognition of inflation as an important macroeconomic factor
and the efforts to mitigate and manage this risk have clearly influenced both policymakers and financial markets. In terms of policy,
one major development has been the adoption of inflation-targeting
monetary policies, which have become standard in most countries.
These policies have helped to stabilise inflation and to anchor inflation expectations. Another important development has to do with
financial markets, where there has been an impressive growth in
traded instruments designed to transfer and manage inflation risk.
In terms of inflation markets, the initial step was the issuance of
inflation-linked bonds. The UK and several Latin American countries were among the first to issue such products in the 1960s, 1970s
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and 1980s, and they did so in a period of high realised inflation. A

further milestone in the development of the inflation market was
reached in the late 1990s, when the US and France started their
inflation bonds programmes.
The next step in the evolution of the inflation market, as more
complex flows developed and more sophisticated investors became
involved, was the birth of inflation derivatives (swaps and options
in particular), which are the focus of this chapter.
In the following, we shall provide some historical perspective as
a way to aid our understanding of the origin of the inflation market,
and why it evolved the way it did. In addition, we shall explain the
detailed mechanics of the most common inflation derivatives, swaps
and options. Indeed, such products have several technical subtleties
of which a trader or a portfolio manager must be aware. Finally, we
shall show how to build some of the practical tools that are necessary
when trading inflation products in the real world.
INFLATION SWAPS: A HISTORICAL PERSPECTIVE
Pension funds: hedging liabilities inflation risk
Pension funds have been early adopters and eager buyers of
inflation-linked bonds. Indeed, this demand was one of the key reasons for governments to issue inflation-linked bonds to begin with.
For example, in 1980, the Wilson Report recommended that the UK
Government issue index-linked gilts to meet pension funds demand
(Wilson Committee 1980). The Economic Progress Report published
by the UK Treasury1 in May 1981 stated the following.
There is no doubt that [the introduction of indexed gilts] will in
time have significant effects on the pension industry. It is far too
soon to predict how the generality of funds will adapt to the availability of such an asset but over time the private sector pensions
industry will gain [an] additional element of flexibility in tailoring
benefits it can offer. Some companies have already begun to offer
index-linked retirement annuities for self-employed.
Nostradamus would not have been any better at foreseeing the

future. Those predictions came true, not only in the UK but also in
other countries with large pension schemes (such as Canada, Brazil,
the Netherlands, Denmark, South Africa and Australia). Furthermore, the consequent tailoring of pension benefits contributed to
the birth of the inflation derivatives market.
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UNDERSTANDING AND TRADING INFLATION SWAPS AND OPTIONS
Figure 8.1 Inflation risk in defined benefit pension funds liabilities

One member
Pension fund
cashflows
( thousands)
Member retires
50
25
0
Years
2.
Inflows
All scheme members

100
Pension fund
cashflows
( millions)
Member dies
1.
Outflows
Inflation
75
50
25
0
Years
During the accumulation period (inflows) the pension contributions are implicitly
linked to wage inflation. During the payment period (outflows), pension annuities
may be explicitly linked to consumer price inflation. 1. In the UK the annuities are
linked to the RPI. In the Netherlands the annuities can be linked to the CPI. 2. The
first annuity is generally proportional to the final contribution.
At this point, we shall review the reasons why pension funds are
exposed to the risk of unexpected high inflation in the future. Simply
put, a pension fund cashflows stream can be split into two periods,
as shown in Figure 8.1:
1. during the accumulation (cash inflows into the pension fund)
period, pension scheme members contribute funds via regular
instalments during their active working life;
2. when members reach retirement age, the distribution (cash
outflows from the pension funds) period begins, and the retiree
receives a pension annuity until their death.
The inflation sensitivity of these cashflows is a function of actuarial
projections and accounting valuations. The latter are in turn influenced by pension regulations, which differ from country to country
and evolve over time. But the crucial point is to understand how
price levels affect the initial amount of benefits payable and their
growth over time.
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In most defined benefits2 pension schemes, the initial annuity

is often based on the latest salary before retirement; as a result, the
higher the wage inflation during the contribution period, the higher
the pension liabilities. Another source of inflation sensitivity comes
from the contractually specified formula for the growth in the annuity amount over time. In some countries, such as the UK and the
Netherlands, pension annuities increase contractually at the inflation rate. As a result of these factors, an increase in expected inflation rate increases the expected amount of initial annuity payable,
as well as its yearly growth.
This risk is further compounded by several other factors. First,
pension liabilities have long maturities, as they are based on life
expectancy after retirement, so that they concentrate around the
1020 year term, but can be as long as 60 years or more. This
means that there is a high sensitivity to future inflation assumptions, given that, for calculating benefits payable, projected inflation
is cumulated each year from inception to the actual distribution date.
This is an important issue, as there is great uncertainty around the
path of future inflation, and forecast errors are significantly high,
particularly after a three-year horizon.
Second, because of the relevance inflation risk has for these institutions, it should come as no surprise that the development of inflation products has been closely intertwined with the growth in hedging needs and sophistication of pension funds. Indeed, the birth of
the inflation market initiated a virtuous-cycle type of development
for both inflation products and the pension industry. We shall now
review some important steps in this evolution, culminating with the
birth of inflation derivatives.
1. The issuance of the first inflation-linked bonds created a tradeable forward inflation rate. This helped actuaries in setting the
inflation assumptions used to project the pension funds benefits payable. Previously, actuarial inflation assumptions were
not really consistently set, and each pension fund would generally use different assumptions. Some popular choices included
monetary policy inflation target levels, or long-term inflation
assumptions as embedded in the Taylor rule (Taylor 1993).
With the issuance of inflation-linked bonds, a break-even inflation (BEI) rate could for the first time be derived from the
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market price of traded securities (inflation-linked and nominal

bonds).
2. Market liquidity of inflation-linked bonds improved, and
additional bonds were issued with different initial maturities,
thus helping to build a more complete (less sparse) BEI curve.
As a result, pension funds and regulators could quantify more
precisely the present value of future liabilities and their sensitivity to inflation, which initiated the discussions to encourage
pension funds to account for inflation risk explicitly.
3. Gradually, pension funds started to measure the sensitivity of
the value of their future liabilities to changes in BEI rates, and to
manage this risk. As a result, pension funds began allocating
some of their assets into inflation-linked bonds, as a way of
providing a rough hedge to the inflation sensitivity arising
from their liabilities. However, these early hedges were far
from perfect, as the inflation bonds cashflows (concentrated in
a few benchmark maturities) were a poor match to the more
dispersed pension liability cashflows.
4. New pension regulations played an important role in shaping
the inflation-hedging strategies of pension funds. For example, in the UK, the Pension Act of 1995 enforced the indexation
of pension payments to inflation, subject to a yearly cap of
5% (Davis 2000). This spurred pension funds to look for more
accurate hedges for their liabilities and, in turn, led investment banks and asset managers to structure tailor-made inflation hedges. This ultimately resulted in the birth of inflation
swaps, where pension funds would typically elect to receive
inflation-linked cashflows in exchange for paying a fixed rate.
Such derivatives contracts had several advantages. First, they
transferred most of the inflation risk from the pension fund to
the swap counterpart. Second, they did not require the pension
funds to make any initial capital investments, unlike inflationlinked bonds. Such swaps became an (almost) capital-free
overlay to many pensions liabilities.
5. Over time, the use of inflation derivatives to hedge pension
funds liabilities became widespread and a new industry, specialising in such hedging technology, emerged. For example,
in the UK, most inflation swaps are executed by specialised
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asset managers, which acted on behalf of their pension fund

clients.
6. Other countries, such as the Netherlands, implemented similar
regulations, which helped the development of both their local
inflation-linked bond and swap markets.
Since 2000, the virtuous cycle of demand and supply of inflationlinked cashflows has resulted in increased inflation-hedging activity,
limited only by the risk capacity of investment banks, the topic of
the next subsection.
Investment banks: managing inflation risk
The rapid growth in inflation-hedging activities since the early 2000s
transferred a large amount of inflation risk onto the banks trading
books. As banks were limited in the size of risk they could take,
they hedged their inflation exposure with inflation-linked bonds.
The main idea was to extract the inflation cashflows from the inflation bonds and to recycle them to pension funds via swaps. That
left the banks trading books more or less immune to moves in forward inflation rates. Indeed, such moves would change the inflationlinked bond prices, but this change would mirror and therefore offset
the change in the value of the swap.
However, such hedging techniques created other risks. An important one was the discrepancy of funding costs between the nominal
and the inflation bonds. This problem was exacerbated by the gradual accumulation of long-dated inflation swaps. This led banks to
look for other ways to hedge inflation risk more accurately. Part of
the solution was found within the financing of infrastructure or real
estate assets. Infrastructure and real estate assets have long-term
streams of revenues linked to inflation. These cashflows have the
opposite inflation risk to that faced by pension funds, and an increase
in forward inflation increases the present value of these assets, as it
increases the pension funds liabilities. As a result, some of the banks
providing financing for infrastructure assets were able to structure
back-to-back swaps (Figure 8.2), where they would receive inflation cashflows from the infrastructure client, and pay these inflation
cashflows to the pension fund client on the other side of the swap.
Such transactions were clearly more cost effective, as they did not
involve the purchase of inflation-linked bonds (linkers).
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Figure 8.2 Recycling inflation from a project finance deal into a

pension fund via swaps
Project
finance
(revenues
linked to
inflation)
Inflation
Inflation
Pension
funds
Banks
Swap break-even
inflation
Swap break-even
inflation
However, such back-to-back transactions could not solve the

whole problem. The size of pension funds inflation liabilities, and
consequent hedging demand, was indeed huge and could not be
met by these financing transactions alone. In addition, these project
finance swaps increased the credit exposure to sectors in which the
banks already had large concentration risk.
As a result, inflation-linked bonds remained the main hedging tool
used by banks to hedge inflation swaps with pension funds. This created structural positions in banks trading books, which often caused
price distortions between the bonds and the derivatives markets and
also led to the development of linker asset swaps.
Retail demand and inflation-structured notes
Another important step for the inflation market was the development of inflation-structured notes, which occurred independently
of the inflation-hedging activity by pension funds, and did not ease
the issue of inflation risk on banks trading books (in fact it made it
even worse).
The structure of most inflation-linked bonds is such that inflation is cumulated over the life of the bond, and mainly paid in a
large cashflow at maturity. As a result the yearly coupon is generally lower than that for a nominal bond of similar maturity, which is
not an attractive feature for some investors. Another issue is the tax
treatment of the inflation-linked bond. Typically, taxes are due not
only on the yearly coupon but also on the inflation-accrued notional
over the fiscal period, albeit the latter is paid only at maturity.
This lag between the tax and the cashflow payments led banks to
structure inflation-linked structured notes where the accrued inflation is paid along with the coupons and the tax is paid at the
same time as the cashflow payments. In this structure, the issuer
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Figure 8.3 Flows of a bank hedging the inflation cashflows of a

structured note
2%+ inflation
+ inflation YoY floor
2%+ inflation
+ inflation YoY floor
Note
issuers
Bank
Floating rate
Note
buyer
Cash at inception
typically hedges inflation risk by entering an inflation swap with an

investment bank via another inflation swap (Figure 8.3).
Such hedges transferred the inflation risk into the banks trading books. In a similar way as before, banks bought linkers to
hedge the risk. However, an important difference in the pension
funds case is that the maturity of the structured notes was usually
shorter (typically five years), which created additional demand for
short-maturity inflation bonds. This demand was met by government issuers such as the Italian Treasury, which issued one of the
first short-dated inflation-linked bonds, contributing to improved
liquidity at the short end of the real curve.
All these developments focused the market on the need to actively
manage and efficiently transfer inflation risk, leading to the birth of
the interbanking market for inflation swaps.
UNDERSTANDING THE INFLATION SWAP MARKET
Inflation swaps developed on the back of pension funds hedging activities. Therefore, it is not surprising that the swaps standard adopted by the interbank market is close to the structure
used in hedging pension liabilities. Typically, pension funds cashflows grow with the inflation rate. An inflation swap exchanges the
unknown inflation rate into a market-determined fixed rate.
Zero-coupon inflation swaps
A zero-coupon inflation swap (ZCIS) involves the one-off exchange
at maturity of an inflation-linked cashflow versus a fixed amount.
The counterparty receiving inflation will be compensated for the
cumulative inflation accrued over the term of the swap against the
payment of amount accruing at a fixed rate, agreed upon at inception. This rate is equivalent to the average annual forward inflation
rate over the period. Note that the maturity of the swap can be very
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Figure 8.4 ZCIS quotes as of July 26, 2011, for the French and the
EMU HICPs (Bloomberg tickers: FRCPXTOB and CPTFEMU)
Figure 8.5 ZCIS cashflows

(1 + 2.285%)10
Bank
Counterpart
CPI(10Y 3M)
CPI(today 3M)
long, from one year to up to fifty years, which is not surprising as

pension funds liabilities are long term in nature.
As an example, consider the 10Y EMU (European Monetary
Union) inflation swap. According to the quote circled in Figure 8.4, a
bank will agree to receive the 2.285% ask rate in exchange for realised
inflation over the course of the swap, both compounded to and paid
at the final maturity date, 10 years from inception. Note that realised
inflation measured by the change in the CPI values with a lag of three
months (3M). Other conventions exist as shown in Table 8.1. See Figure 8.5 for a representation of the swap cashflows, and Table 8.1 for
a summary of different market conventions.
Year-on-year inflation swaps
A common variation to zero-coupon swap is the year-on-year (YoY)
inflation swap, mirroring the cashflows of the structured inflationlinked notes introduced before. For example, in a YoY swap, the
receiver of inflation will be paid the index return each year until
maturity (usually with a lag, as before). Clearly, the pricing of such
145
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Source
US
Japan
UK
Australia
Ex-tobacco
HICP
Unrevised
NSA
Ex-tobacco
CPI
Unrevised
NSA
CPI
urban
Unrevised
NSA
Ex-fresh
food CPI
Unrevised
NSA
RPI All
items
Unrevised
NSA
RPI All
items
Unrevised
NSA
Eurostat
INSEE
BLS
MPM
ONS
ABS
Bloomberg
CPTFEMU
<Index>
FRCPXTOB
<Index>
CPURNSA
<Index>
JCPNGENF
<Index>
UKRPI
<Index>
AUCPI
<Index>
Frequency
Monthly
Monthly
Monthly
Monthly
Monthly
Quarterly
Straight
Swap inflation index

Lag
Liquidity
The
France
Straight
Daily
Daily
Daily
Straight
3M
2M3M
2M3M
2M3M
2M
1Q
High
Medium
High
Low
Medium
Medium
swap index changes once a month. The swap index is calculated daily as a linear interpolation between two consecutive inflation indexes.
perrucci 2012/7/11 17:12 page 146 #168
CPI
EMU
146
Table 8.1 Different market conventions for inflation swaps
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cashflows requires a forward Consumer Price Index (CPI) curve, as

the future YoY inflation rate at time t is defined by
YoY(t) =
CPI(t lag)
1
CPI(t 1Y lag)
Part of the forward CPI curve can be derived directly from the zerocoupon swap rates (ie, for the maturities for which ZCIS are quoted).
If we take the example of the previous section, we can calculate the
10Y forward CPI with a three-month lag from the quoted price of the
10Y ZCIS 2.285% as follows (note that the initial index CPI(today
3M) is a known quantity, which is worth 112.75 in the example)
CPI(10Y 10M) = CPI(t 3M)(1 + 2.285%)10
= 112.75(1 + 2. 285%)10
= 141. 33
However, these yearly points are incomplete and need to be extended to monthly or daily points in order to recover the whole
pricing curve, a topic covered in the next subsection.
Convexity adjustments in YoY inflation swaps
Prices of YoY swaps are not really observable, but can be derived
from ZCIS prices, although appropriate convexity adjustments are
required. These adjustments come from the fact that the YoY inflation
swaps (YYISs) can only be partially hedged with a portfolio of ZCISs,
as we shall see later. These mismatches are quantified by using specific stochastic models. Each trader has their own model and calibration techniques. As a result, the adjustments, and therefore the
pricing of YoY swaps, can differ materially.
Incidentally, at-the-money (ATM) YoY inflation option prices also
differ, given the lack of consensus on the pricing of the underlying.
Indeed, the strikes of YoY inflation options are expressed in absolute
levels (typically 2%, 1%, 0%, 1%, 2%, 3%, 4%, 5%) and not as a
spread relative to the current ATM level, as is the case for most
options on nominal yields (for example, ATM +50 basis points).
An intuitive way to understand the convexity adjustment is to
analyse how to hedge a YYISs with ZCISs, which trade in the interbanking market. As an illustration, we shall consider the 10Y cashflows of a YYIS, where the inflation leg is based on the yearly inflation
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Figure 8.6 Hedging a YoY swap with two ZC swaps

Portfolio: YoY
inflation swap
Hedge with two
ZC inflation swaps
10Y
2.2%
I10 / I9
1.94%
9Y
10Y
I9 / I0
I10 / I0
1.97%
Reinvestment rate r9
2.0
300
1.5
200
Millions
1.0
100
0.5
0
0.5
1.0
1.5
2.0
1.5
Portfolio
Hedge
Long portfolio,
short hedge
1.0
0.5
0
0.5
1.0
Change in 9Y and 10Y BEI (parallel shift, %)
100
200
300
1.5
Long portfolio, short hedge (thousands)
Figure 8.7 Impact of changes in BEI9 and BEI10 (parallel shift) on the
global P/L for a notional of 100M: positive convexity
rate, which will accrue between 9Y and 10Y; we denote this stochastic cashflow by YoY9,10 . The question is: what is todays value of this
cashflow or the break even inflation rate (denoted by BEI9Y,10Y )?
1. The bank portfolio to be hedged consists of a short position
in a YoY9,10 swap. In other words, in 10 years time, the bank
pays I10 /I9 1 (where I9 and I10 are the stochastic 9Y and 10Y
forward inflation indices) and receives BEI9Y,10Y (a level that is
defined today). Clearly, the profit or loss (P/L) of this position
is proportional to the change in I10 /I9 .
2. The hedge consists of two ZC swaps.
(a) Short 9Y ZCIS: the bank pays I9 /I0 and receives todays
BEI9 in nine years.
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Figure 8.8 Impact of a positive correlation between I9 and the

reinvestment rate r9 : negative convexity
200
150
Thousands
100
50
0
50
Portfolio
Hedge
Long portfolio,
short hedge
100
150
200
1.5
1.0
0
0.5
1.0
0.5
Change in 9Y and 10Y BEI (parallel shift, %)
1.5
Figure 8.9 Inflation zero-coupon and YoY forward inflation curves

calculated using linear and cubic spline interpolation
Forward inflation rate (%)
3.1
2.9
2.7
2.5
2.3
Linear
YoY forward cubic spline
YoY forward linear
Cubic spline
2.2
1.9
1.7
0
10
15
20 25 30
Maturity (years)
35
40
45
50
(b) Long 10Y ZCIS: the bank receives I10 /I0 and pays todays
BEI10 in ten years, where I0 is todays known inflation
index.
The P/L is proportional to the change in the expected value of both
I10 and I9 , and the one-year reinvestment rate r9 of the 9Y net cashflow
into 10Y (Figure 8.6).
The two main sources of convexity are the following.
1. Figure 8.7: the hedge P/L is proportional to the change in the
expected value of I9 and I10 , whereas the YoY swap P/L is not (it
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depends only on the ratio I10 /I9 ). A parallel shift up or down of

both BEI9 and BEI10 (a frequent move) will increase (decrease)
the portfolio P/L (non-linear, black line) more (less) than the
hedge (linear, grey dashed line). Therefore the combined position (YoY swap plus hedge) would make money (positive convexity) whatever the direction of the parallel move is; this effect
should lower the BEI9,10 (positive convexity correction); the
more volatile the BEI is, the higher the convexity correction
will be.
2. Figure 8.8: the P/L of the short ZCIS9 , that is (1+BEI9 )9 I9 /I0 is
reinvested into 10Y and is negatively correlated to the reinvestment rate such that a positive P/L is reinvested at a lower rate,
while a negative P/L is reinvested at a higher rate. This effect
translates into a higher BEI (negative convexity adjustment).
Generally the first effect is higher than the second effect and therefore
the net convexity is usually positive.
Building the yearly forward inflation curve
The first step in building the forward inflation curve is interpolation
in between the maturities quoted in the zero-coupon swap market
(see the market mid column in Table 8.2) and Table 8.3, where
different interpolation methods might be used, such as a simple linear interpolation or a cubic spline methodology (see the fourth and
fifth columns in Table 8.2); the latter are typically preferred as they
produce smoother forward YoY curves (Figure 8.9). Once the yearly
inflation swap rates it are derived, we can calculate the forward
inflation index levels as seen before using the simplified formula
(we assume no lag)
CPI(t) = CPI(0)(1 + it )t
Then we can calculate the YoY implied inflation rates, which will
need to be adjusted by a convexity coefficient, as we shall see in the
next section.
Building the monthly forward inflation curve
When going from the interpolated yearly curve to a more granular
monthly curve, a few new challenges arise.
First, inflation market prices provide poor information for maturities shorter than three years, as inflation swaps are fairly illiquid for
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Figure 8.10 Comparison between an SA and an NSA forward CPI

curve
140
135
130
125
120
NSA forward HICP

SA forward HICP
115
110
11
13
15
17
19
those tenors, and there is no liquid real rate product for short maturities either. However, within the one-year horizon, economists forecasts are fairly accurate and can provide some guidance in building
the short end of the inflation curve.
Another issue has to do with seasonality, as most indexes used in
the inflation market are non-seasonally adjusted (NSA). In addition,
seasonality information can be derived partly from inflation-linked
bonds, but with limited accuracy. Last, seasonality factors change
over time and there is no accepted market standard as to how they
should be computed.
In Table 8.3, we have chosen to use the latest European Central
Bank seasonality factors (European Central Bank 2000) in the sixth
column as the best predictors for future seasonality.
Table 8.3 shows an example of calculations where economists
forecasts (third column) are used as a guide to build the short end
of the curve (fifth column) until December 2012. From January 2013
onwards, the monthly CPI curve is calculated from the yearly forward CPI (4th column) implied by the ZCIS prices. The issue is how
we can build monthly CPI from yearly CPI, which are non-seasonally
adjusted (NSA). As Figure 8.10 shows, the seasonality creates an
oscillating shape, which prevents interpolation. The solution is first
to make the data seasonally adjusted (SA), by dividing the fifth column by the sixth column to obtain the seventh column (labelled as
SA). Then in the eighth column we can interpolate the data to obtain
the monthly SA CPI. In the ninth column we convert the monthly
SA CPI back into NSA CPI.
151
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0Y
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
11Y
12Y
13Y
14Y
15Y
Maturity
06/08/2012
05/08/2013
04/08/2014
04/08/2015
04/08/2016
04/08/2017
06/08/2018
05/08/2019
04/08/2020
04/08/2021
04/08/2022
04/08/2023
05/08/2024
04/08/2025
04/08/2026
1.750
1.770
1.857
1.913
1.975
2.040
2.070
2.107
2.146
2.173
2.201
2.242
1.872
1.886
1.941
1.969
2.033
2.102
2.140
2.173
2.183
2.210
2.260
2.310
2.314
2.319
2.323
1.872
1.886
1.941
1.969
2.033
2.102
2.140
2.173
2.182
2.210
2.262
2.310
2.330
2.329
2.323
HICP
Date
05/2011
05/2012
05/2013
05/2014
05/2015
05/2016
05/2017
05/2018
05/2019
05/2020
05/2021
05/2022
05/2023
05/2024
05/2025
05/2026
Fwd HICP

YoY fwd

Fwd HICP
Linear Cubic spline Linear Cubic spline Cubic spline
112.74
114.85
117.03
119.43
121.89
124.68
127.73
130.75
133.90
136.92
140.29
144.16
148.28
151.79
155.40
159.10
112.74
114.85
117.03
119.43
121.89
124.68
127.73
130.75
133.90
136.92
140.29
144.19
148.28
152.09
155.62
159.10
1.87
1.90
2.05
2.05
2.29
2.45
2.37
2.40
2.26
2.46
2.76
2.86
2.37
2.38
2.38
1.87
1.90
2.05
2.05
2.29
2.45
2.37
2.40
2.26
2.46
2.78
2.84
2.57
2.32
2.24
112.74
114.85
117.03
119.43
121.89
124.68
127.73
130.75
133.90
136.92
140.29
144.19
148.28
152.09
155.62
159.10
perrucci 2012/7/11 17:12 page 152 #174
Tenor
Interpolated curve

Market mid
ICPI
Linear Cubic spline
152
Table 8.2 ZCIS quotes, forward index levels and YoY inflation rates
Trading date: August 3, 2011. Settlement date: August 4, 2011. Yearly tenors.
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Table 8.2 (Cont.)
04/08/2027
04/08/2028
06/08/2029
05/08/2030
04/08/2031
04/08/2032
04/08/2033
04/08/2034
06/08/2035
04/08/2036
04/08/2037
04/08/2038
04/08/2039
06/08/2040
05/08/2041
2.283
2.298
2.377
2.332
2.341
2.351
2.360
2.369
2.371
2.374
2.376
2.379
2.381
2.395
2.409
2.424
2.438
2.452
2.324
2.333
2.346
2.359
2.369
2.374
2.376
2.376
2.377
2.381
2.390
2.404
2.420
2.436
2.452
05/2027
05/2028
05/2029
05/2030
05/2031
05/2032
05/2033
05/2034
05/2035
05/2036
05/2037
05/2038
05/2039
05/2040
05/2041
Fwd HICP

YoY fwd

Fwd HICP
Linear Cubic spline Linear Cubic spline Cubic spline
163.03
167.09
171.28
175.61
180.07
184.43
188.90
193.49
198.20
203.03
208.62
214.41
220.43
226.69
233.18
Trading date: August 3, 2011. Settlement date: August 4, 2011. Yearly tenors.
162.83
166.86
171.13
175.57
180.07
184.53
188.97
193.46
198.11
203.03
208.36
214.10
220.20
226.59
233.18
2.47
2.49
2.51
2.53
2.54
2.42
2.42
2.43
2.43
2.44
2.75
2.78
2.81
2.84
2.86
2.35
2.47
2.56
2.59
2.57
2.48
2.41
2.38
2.40
2.49
2.63
2.75
2.85
2.90
2.91
162.83
166.86
171.13
175.57
180.07
184.53
188.97
193.46
198.11
203.03
208.36
214.10
220.20
226.59
233.18
153
16Y
17Y
18Y
19Y
20Y
21Y
22Y
23Y
24Y
25Y
26Y
27Y
28Y
29Y
30Y
Maturity
HICP
Date
perrucci 2012/7/11 17:12 page 153 #175
Tenor
Interpolated curve

Market
mid Linear Cubic spline
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May 10
Jun 10
Jul 10
Aug 10
Sep 10
Oct 10
Nov 10
Dec 10
Jan 11
Feb 11
Mar 11
Apr 11
May 11
Jun 11
Jul 11
Aug 11
Sep 11
Oct 11
Nov 11
Dec 11
109.71
109.70
109.32
109.54
109.77
110.15
110.27
110.93
110.11
110.57
112.11
112.75
112.74
112.75
Fwd
CPI
112.74
112.25
112.71
113.24
113.67
113.74
114.19
NSA
Seasonals
SA Fwd
SA Fwd
NSA
NSA SA
Fwd CPI
2010
CPI
CPI
MoM
MoM MoM
Forecasts
ECB
(incomplete) Linear Fwd CPI (%) (%)
109.71
109.70
109.32
109.54
109.77
110.15
110.27
110.93
110.11
110.57
112.11
112.75
112.74
112.75
112.25
112.71
113.24
113.67
113.74
114.19
1.0044
1.0044
0.9996
0.9999
0.9998
1.0011
0.9998
1.0005
0.9921
0.9939
1.0007
1.0040
1.0044
1.0044
0.9996
0.9999
0.9998
1.0011
0.9998
1.0005
109.23
109.22
109.36
109.56
109.79
110.02
110.30
110.87
110.99
111.25
112.03
112.30
112.25
112.26
112.30
112.73
113.26
113.54
113.77
114.13
109.23
109.22
109.36
109.56
109.79
110.02
110.30
110.87
110.99
111.25
112.03
112.30
112.25
112.26
112.30
112.73
113.26
113.54
113.77
114.13
109.71
109.70 0.08 0.1
109.32 1.55 4.1
109.54 2.12 2.4
109.77 2.63 2.5
110.15 2.57 4.2
110.27 3.01 1.3
110.93 6.43 7.4
110.11 1.28 8.5
110.57 2.86 5.1
112.11 8.76 18.1
112.75 2.94 7.1
112.74 0.59 0.1
112.75 0.14 0.1
112.25 0.37 5.2
112.71 4.70 5.0
113.24 5.88 5.8
113.67 2.98 4.7
113.74 2.43 0.7
114.19 3.89 4.9
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Tenor
CPI
month (publ.) Forecasts
154
Table 8.3 Building a granular forward inflation curve
i
i
i
Table 8.3 (Cont.)
Tenor
CPI
month (publ.) Forecasts
114.85
117.03
113.08
113.38
114.65
115.05
115.09
115.15
114.49
114.73
115.16
115.43
115.38
115.70
117.03
0.9921
0.9939
1.0007
1.0040
1.0044
1.0044
0.9996
0.9999
0.9998
1.0011
0.9998
1.0005
0.9921
0.9939
1.0007
1.0040
1.0044
1.0044
0.9996
0.9999
0.9998
1.0011
0.9998
113.98
114.08
114.57
114.59
114.59
114.65
114.54
114.75
115.18
115.30
115.41
115.64
116.52
113.98
114.08
114.57
114.59
114.59
114.65
114.54
114.75
115.18
115.30
115.41
115.64
115.82
116.00
116.17
116.35
116.52
116.72
116.92
117.12
117.33
117.52
117.73
113.08 1.5411.1
113.38 1.00 3.2
114.65 5.30 14.3
115.05 0.25 4.3
115.09 0.07 0.4
115.15 0.66 0.6
114.49 1.18 6.7
114.73 2.22 2.5
115.16 4.68 4.6
115.43 1.20 2.9
115.38 1.15 0.5
115.70 2.43 3.4
114.90 1.90 8.0
115.29 1.89 4.1
116.25 1.71 10.4
116.81 1.89 6.0
117.03 1.82 2.3
117.23 2.11 2.1
116.87 2.04 3.6
117.11 2.10 2.4
117.30 2.10 2.0
117.66 2.03 3.7
117.70 2.09 0.4
perrucci 2012/7/11 17:12 page 155 #177
113.08
113.38
114.65
115.05
115.09
115.15
114.49
114.73
115.16
115.43
115.38
115.70
NSA
Seasonals
SA Fwd
SA Fwd
NSA
NSA SA
Fwd CPI
2010
CPI
CPI
MoM
MoM MoM
Forecasts
ECB
(incomplete) Linear Fwd CPI (%) (%)
155
Jan 12
Feb 12
Mar 12
Apr 12
May 12
Jun 12
Jul 12
Aug 12
Sep 12
Oct 12
Nov 12
Dec 12
Jan 13
Feb 13
Mar 13
Apr 13
May 13
Jun 13
Jul 13
Aug 13
Sep 13
Oct 13
Nov 13
Fwd
CPI
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From this curve, the inflation cashflows of most vanilla inflation products can be calculated and priced. However, more complex cashflows, which involve non-linear payouts or are based on
a forward starting index, require a full distribution and correlation
structure. Some of this information can be extracted from inflation
options, the topic of the next section.
INFLATION OPTIONS: A HISTORICAL PERSPECTIVE
This section will focus on options, in particular zero-coupon and
YoY inflation caps and floors, which are the most liquid inflation
options. We shall not cover more exotic instruments such as options
on real yields, inflation swaption or hybrid inflation options, which
would add too many dimensions to fit within one chapter. Readers
interested in a more complete analysis can refer to Bnaben and
Tabardel (2008) and Brigo and Mercurio (2006).
Floors in inflation-linked government bonds
When the US and France issued their first inflation-linked bonds in
the late 1990s, they embedded an inflation floor for the principal
payment at maturity. As some large institutional investors can only
invest in bonds that pay a guaranteed principal amount at maturity,
but cumulated inflation can in principle be negative, these issuers
added a principal protection in the form of an inflation floor. In other
words, at maturity T, the investor in the inflation-linked bond issued
at t = 0 receives

I (T )
, 100% notional
max
I (0)
where I (t) is the inflation index at the maturity of the linker and I (0)
is the inflation index underlying the linker. In practice, these deflation floors were given little attention, as their value was perceived
to be negligible, because most countries were experiencing inflation
rates within the range targeted by their monetary policies, and a
deflation episode would have to persist for a long time to affect the
redemption floor of long-maturity linkers.
In fact, both traders and investors regularly ignored these options
when valuing the linkers,3 and in the rare cases where they tried
to account for them explicitly, the models used were typically calibrated on historical data (when inflation was positive and stable),
so the risk was underestimated and not managed correctly.
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Figure 8.11 Issuance of YoY inflation structured notes

US CPI
UK RPI
Swedish CPI
Spanish CPI
Not specified
Italian CPI
Icelandic CPI
Eurozone HICP (inc tobacco)

Eurozone HICP (ex tobacco)
Colombian CPI
Chilean CPI
Brazilian IPCA
Basket
20,000
15,000
10,000
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
5,000
1988
Sum of US dollars (million) equivalent
25,000
Year of issuance
Source: Bloomberg, New Sky Capital, BNP Paribas.
The complacency from the world of practitioners did not prevent the academic world from working on a modelling framework
for valuing these options. For example, Robert Jarrow and Yildiray
Yildirim (2003) published on this topic, and provided a mathematical
formulation of how to the price the inflation floor.
The structured inflation notes market and YoY inflation options
Inflation trading desks started to look carefully at such models gradually, as the option risks on their books grew, which happened
hand in hand with the development of the inflation-structured notes
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market. As mentioned before, strong retail demand developed (particularly in Italy) for inflation-protected structured notes. To meet
this demand, investment banks helped issuers to structure inflationlinked notes, with a typical maturity of around five years and an
annual coupon, comprising a fixed rate (say, 2% for our illustration) plus the realised year-on-year inflation. As a coupon cannot be
negative, the coupon paid at t was
max[2% + YoY(t), 0]
In other words, the annual coupons had an embedded inflation floor
at 2%. The issuers of such notes did not carry the inflation risk,
which was transferred to the trading books of the investment banks
via a swap. In other words, the investment banks were paying this
floored inflation to the issuers. In the absence of an inflation option
market, these floors were priced based on historical data, which
generally covered a period a relatively stable positive inflation. As
a result, the cost of such floors, as well as their risk, was underestimated. Indeed, many banks kept these short floor positions partially unhedged, with only limited reserves set aside to cover the
event of an increase in value (a loss on the short position). Over
time, the inflation-structured notes market grew significantly (Figure 8.11), due in part to the rise in commodity prices and its impact
on inflation.
These products became particularly popular with retail investors
in Europe and in the US. As shown in Figure 8.11, the peak of issuance
corresponds to 2007 (a year during which oil prices doubled) and the
first half of 2008 (when oil prices increased by about 50%). Because
of this large amount of issuance, banks accumulated large shortoption positions, mainly in YoY inflation floors struck at 0%. As the
risk grew, banks turned to other banks and brokers to offset their
exposure, which then gave birth to the interbank option market.
This is the main reason why the YoY format remains the most common structure in the inflation option market, in contrast to the swap
market, where the zero-coupon structure (similar to the cash bond)
tends to prevail.
The hard awakening of risk management in inflation option
books
The inter-broker market had an important consequence: it provided
market prices for inflation options. As a result, the positions in banks
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Figure 8.12 Change in delta while BEI decreases for 1M YoY floor
3
Change in BEI levels (%)

2
1
0
100
200
300
400
500
600
Change in delta (in ) for

a 1M 10Y YoY 0% floor
700
books started being marked-to-market, and the banks started hedging their trading book more actively. However, all banks had similar positions: they were short YoY floors and, consequently, they
could not really cover their exposures in the interbank market. That
led most banks to partially hedge these options, more precisely to
delta hedge the options; they sold a quantity of the underlying
inflation swap (by paying inflation and receiving a fixed rate), such
that the option price was immunised against changes in the price of
the underlying swap. Like in any option the delta hedge ratio varies
with the proximity to the strike price. Most of the floor levels were
around 0%, therefore the closer the BEI was to 0%, the more inflation
swap the banks had to sell to hedge the delta of the option.
As long as the BEI levels were stable at around 2% or 3%, this
hedging strategy worked well, with the banks pocketing the carry
of these options. Indeed, the issuance of YoY structured notes kept
rising until 2008. After the collapse of Lehman Brothers, the liquidity
crisis forced the trading books to sell most of their inflation-linked
bonds, causing BEI levels to collapse to unprecedented levels. For
example, in the US, the market was pricing deflation over a 10-year
horizon! The drop in BEI levels was also exacerbated by the hedging of these floors. In fact, as the BEI started decreasing and got
closer to the 0% strike, inflation option desks had to adjust their
delta hedge by selling more inflation swaps (Figure 8.12). This put
further pressure on BEIs, which in turn forced the inflation option
books to sell more swaps, and so on. This vicious circle caused huge
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losses in inflation trading desks, and the issuance of YoY structured

note plummeted.
This episode shows how the tail risk in 0% strike inflation floors
was given little attention, and led banks to concentrate one-way
positions and implement the same hedging strategy. When the crisis
hit, this triggered major losses. The irony of the story is that this crisis
caused an unexpected development in the inflation option market,
ie, the development of inflation zero-coupon options, which is the
topic of the next subsection.
The development of zero-coupon inflation options
Previously, we discussed how inflation trading books had a short
structural position in inflation swaps, where banks paid inflation
and received a fixed-rate payment. Due to the lack of inflation payers
in the swap market, the banks hedged these positions by buying
inflation-linked bonds and selling nominal bonds.
One of the consequences of the liquidity crisis in September 2008
was the sudden quasi-closure of the repo market for inflation-linked
bonds. At the same time, the investment banks had to quickly
deleverage their balance-sheet, and one of the ways to do this was to
reduce inventory by selling their inflation bonds while trying to buy
inflation swaps to hedge their structural short position. This triggered one of the biggest disconnections of BEI pricing between the
cash and the derivatives market, with bond BEIs becoming much
cheaper than swap BEIs.
Gradually, some institutional and corporate investors took advantage of this price disconnection. They bought linkers in asset swaps,
where they paid to the banks the inflation cashflow of the bonds;
in other words they supplied the banks with inflation via swaps,
and received a floating payment or fixed payments that embedded
the large premium caused by the price distortions. It is important
to stress that this premium was not due to the rise in credit risk but
to a distortion of the inflation market. As a result, inflation bonds
cheapened in asset swaps (see Chapter 7 for an introduction to asset
swaps) much more than the nominal bond (both from the same government issuer). Over the course of 2009, investment banks sold a
very large amount of asset swaps to various institutional and corporate investors and the distortions were partly corrected by the end
of the year (Figure 8.13).
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Figure 8.13 The difference between US bond and swap 10Y BEIs from
2006 to 2012
180
160
Basis points
140
120
100
80
60
40
20
0
Mar
2006
Mar
2007
Mar
2008
Mar
2009
Mar
2010
Mar
2011
Mar
2012
Figure 8.14 How selling the asset swap partly hedges the short
pension fund inflation swaps and the short YoY floors
Inflation
bond
issuers
1.
Floating
rate
ASW
buyer
Inflation
Pension
funds
Banks
2.
Fixed
rate
1. Debt: real cashflows plus inflation plus redemption inflation floor. 2. Swap: real
cashflows plus inflation plus inflation floor.
What is the connection between the asset swap market and the
option market? In fact, by selling asset swaps the banks bought some
zero-coupon inflation options. Indeed, they received the cashflows
of the linkers via swaps and for most linkers the final cashflows were
floored. This fixed not only the issue of hedging the pension fund
swaps but also, partly, the short YoY floor positions (Figure 8.14).
A long ZC inflation floor position partly hedges a short YoY floor
position. Intuitively, the CPI ratio of a ZC inflation swap is the product of CPI ratios of YoY Inflation swaps. Taking the logarithm of this
product, we get

ln
CPI(T )
CPI(0)

CPI(T )
CPI(T 1)
CPI(1)
= ln
+ ln
+ + ln
CPI(T 1)
CPI(T 2)
CPI(0)
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Figure 8.15 YoY caps and floors quotes (euro HICP)
Sources: Bloomberg, Tullett Prebon.
Taking the variance of the equation, we see that the ZC inflation

volatility is connected to the YoY volatilities and their correlation (see
Belgrade et al (2004) for the mathematical treatment of this topic).
UNDERSTANDING THE INFLATION OPTION MARKET
Understanding the YoY inflation option
The first and most liquid inflation option trading in the interbanking market is the YoY inflation cap (floor). A YoY cap (floor) with a
maturity T consists of T caplets (floorets).
In other words, the buyer of a YoY cap with a strike K and a
maturity T will receive, each year from t = 1 to T, the max(YoY(t)
K, 0) in exchange for an upfront premium.
Figure 8.15 shows a broker screen for such a cap. For example, the
10Y 5% YoY cap will cost an upfront premium equal to 2.58% of the
option notional.
The YoY inflation options are the most liquid option (see Table 8.4)
but, as we have seen in the previous section, the liquidity of the ZC
inflation options rose significantly after 2008 and therefore they have
become the second pillar of the inflation option market.
Understanding the zero-coupon inflation option
A more recent inflation option in the interbanking market is the
ZC inflation cap/floor. This option stems directly from the maturity floor, which exist in most inflation bonds. A ZC inflation cap
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Figure 8.16 ZC caps and floors quotes (euro HICP)
Source: European Central Bank (2000).
Table 8.4 Assessment of liquidity in inflation swaps (linear) and options

(non-linear)
ZC
YoY
Currency
Linear
Non-linear
Linear
Non-linear
Euro
Sterling
US dollar
Good
Good
Good
Medium
Low
Low/medium
Low
Low
Low
Good
Medium
Medium
(floor) with maturity T consists a call (put) option on the ZC inflation

I (t)/I (0) 1. In other words, a buyer of a ZC inflation cap with a
strike K and a maturity T will receive max[I (T )/I (0)(1 + K )T , 0] at
maturity T, in exchange for an upfront premium. Figure 8.16 shows
a broker screen for such a cap. For example, the 10Y 5% ZC cap will
cost an upfront premium equal to 0.85% of option notional.
Note that this premium is less than that of the 10Y 5% YoY ZC
cap. Indeed, the ZC cap is a cap on the average inflation rate over
10 years, whereas the YoY cap incudes a caplet for each year. The ZC
cap will not protect the buyer if the inflation rate is above 5% for a
couple of years but below 5% on average during the 10-year term;
the YoY cap will.
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Figure 8.17 BEI rates for 1Y, 5Y, 10Y and 30Y ZC swaps: (a) EMU
HICP and (b) US CPI
4.0
(a)
3.5
3.0
2.5
2.0
1.5
1.0
1Y
5Y
10Y
30Y
0.5
0
0.5
Nov Nov Nov Nov Nov Nov Nov Nov Nov
2003 2004 2005 2006 2007 2008 2009 2010 2011
4.5
(b)
2.5
0.5
1.5
3.5
5.5
Mar
2004
1Y
5Y
10Y
30Y
Mar
2005
Mar
2006
Mar
2007
Mar
2008
Mar
2009
Mar
2010
Mar
2011
Comparison between historical and implied volatility

The historical analysis of inflation options is based on the underlying
inflation swap prices. So, the initial step is to look at the history of
BEI rates for the EMU HICP and the US CPI swaps. In Figure 8.17
we identified three periods:
1. a pre-2008 period of relatively stable curves;
2. a sharp drop and steepening of the curves during the 2008
crisis; and
3. a partial normalisation from 2009 onwards.
The next step is to analyse the YoY forward BEI rates and their volatility, which is measured by the standard deviation of their changes.
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Figure 8.18 Realised volatility for forward BEI rates (1Y BEI, the 1Y in
2Y BEI and the 1Y in 10Y BEI) for (a) the EMU HICP and (b) US CPI
inflation swaps
4.0
Realised volatility (%)
3.5
10Y CPI
2Y CPI
1Y CPI
3.0
2.5
2.0
1.5
1.0
0.5
(a)
0
Nov
Nov
2003 2004
12
Realised volatility (%)
10
Nov
2005
Nov
2006
Nov
2007
Nov
2008
Nov
2009
Nov
2010
Nov
2011
10Y CPI
2Y CPI
1Y CPI
8
6
4
2
(b)
0
Mar
Mar
2004
2005
Mar
2006
Mar
2007
Mar
2008
Mar
2009
Mar
2010
Mar
2011
Looking at Figure 8.18 we can see that the peak of volatility occurs
in 2008.
Note that the YoY volatility presents some jumps; this is partly due
to the fact that the forward curve is extracted from the zero-coupon
inflation curve. In spite of the smoothing techniques used to derive
this curve, an important issue is the difference of liquidity between
the points of the curve. For example the 10Y zero-coupon swap rate
is certainly the most liquid point, but the 11Y rate is not so liquid
and its level is also dependent on the interpolation methods. These
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Figure 8.19 Comparison of implied YoY at the money volatility of caplet

and historical volatility for (a) EMU HICP and (b) US CPI
2.2
2.0
1.8
1.6
1.4
%
1.2
1.0
0.8
0.6
0.4
(a)
0
10
15
20
25
30
3.1
2.6
2.1
%
1.6
1.0
(b)
0.6
10
15
20
25
30
, realised volatility on YoY CPI swaps; , implied volatility on ATM cap/floor on

YoY CPI;
, power (implied volatility on ATM cap/floor on YoY CPI).
jumps are particularly frequent in the US curve, which is less liquid

than the EMU HICP curve.
Figure 8.19 compares historical and implied volatilities for caplets.
The implied YoY ATM volatility curves in the US and the eurozone
have the downward slopes, which implies mean reversion of BEI
rates. This is partly reflected in the realised volatility in the eurozone,
but not really reflected in the US curve. The US inflation swap is
illiquid except for 10Y swaps and, to some extent, the 2Y and 5Y
swaps. The liquidity for maturities higher than 10Y is limited due to
the absence of 30Y Treasury Inflation Protected Securities (TIPS) until
2010 (which would be the hedging instrument used to hedge long
maturity inflation swaps). This explains why the realised volatility
appears to increase after the 10Y maturity.
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INFLATION OPTION MODELS

In this section we shall detail the evolution of inflation model in
finance. We shall focus more on the concepts than on the mathematical formulation (for the latter, see, for example, Brigo and Mercurio
2006).
Macroeconomic models of inflation
Inflation is, above all, a macroeconomic phenomenon, measured by
a price index such as the CPI. It is therefore not surprising that
the first approaches to modelling inflation were the work of macroeconomists. An important contribution was the monetary exchange
equation, suggested by Irving Fisher in 1911
Mt v = Pt Qt
Where Mt is the money supply during year t, v is money velocity
(ie, how many times per year each money unit is spent), Pt is the
price of goods and services sold during year t and Qt is the quantity
of goods and services sold during year t. From this equation, Fisher
derived the so-called Fisher equation (see, for example, Belgrade
et al 2006)
1 + rn
(1 + i) =
1 + rr
where rn is the nominal rate, rr is the real rate and i is the inflation rate. Rewriting this equation with inflation measured by the
change in CPI over period t and using instantaneous continuously
compounded nominal and real rates gives

ln
CPI(t)
CPI(0)
= (rn rr )t
The Fisher equation is key to the financial modelling of inflation,

as it defines the CPI as the translation mechanism from the nominal
world and the real world, suggesting the currency analogy discussed
in the next section.
The JarrowYildirim model and the currency analogy
Jarrow and Yildirim (2003) used a HeathJarrowMorton (HJM)
model to price TIPS and related derivatives. At that time, the derivatives market was in its infancy, and the interbanking market did
not provide any reliable prices for inflation swaps; only TIPS were
liquid enough and their pricing information sufficiently reliable. So
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Figure 8.20 Currency analogy: non-arbitrage conditions
Real
economy
Deposit interest rate rr

100er,t
100
Spot FX rate
CPI(0)
Forward FX rate
CPI(t )
Nominal
economy
100er,t CPI(t )
100 CPI(0)
Non-arbitrage
100er,t CPI(0)
Deposit interest rate rn

CPI(t )
= exp(rn rr)t
CPI(0)
Fisher
equation
it is not surprising that the first models dealt with the inflation structure characteristics of TIPS. In their paper, Jarrow and Yildirim fitted their model to TIPS prices, nominal Treasuries prices and the
US CPI. Next, they tested the model for pricing TIPS via its hedging performance and, finally, they used it to price a ZC inflation call
option.
Their approach is an interesting one, as the methodology is based
on an analogy with a currency model. It is illustrated in Figure 8.20.
The CPI acts as an exchange rate between the nominal economy
and the real economy. Indeed, the forward CPI(t) is defined by nonarbitrage conditions. Specifically, in the real economy, $100, say, is
invested in a deposit at a real rate rr (dotted arrows) until maturity,
when the proceeds are converted to the nominal economy at a prefixed forward FX rate of CPI(t). Alternatively, $100 is converted into
the nominal economy at the spot FX rate CPI(0) (solid arrows), proceeds are invested at the nominal rate rn . In a non-arbitrage world,
the two investments must have the same return, leading us to define
the forward CPI ratio, which measures the return due to inflation as
the differential return between the nominal and real rates; this is
precisely the Fisher equation.
Jarrow and Yildirim added a stochastic component to both nominal and real rates, as well as the currency/inflation index. The
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model assumes that the volatilities and correlations are (T t)

dependent but deterministic and historically calibrated (to accommodate the mean reversion feature of the BEI/downwards volatility curve shown in Figure 8.19). One of the important advantages
of their model was to set the non-arbitrage conditions and to derive
a three-factor HJM-type model. The model can be summarised as
follows.
Real rates and nominal rates are normally distributed and have
a non-zero short-term correlation (n,r ).
The CPI acts as an exchange rate between the nominal and the
real economy; it has a lognormal distribution and non-zero

correlation with both nominal and real rates.
Under the nominal risk-neutral probability Qn we can derive
the prices of both nominal and real bonds, as well as the

dynamics of the inflation index, which can be used to price
inflation options (a cheat sheet is provided in the appendix;
notation conventions, specific formulas and their derivations
can be found in the appendix at the end of the chapter).
Note that, in this model, the expected instantaneous inflation rate
is given by the difference between nominal and real instantaneous
rates. The model is fitted to the term structure of nominal and real
rates and the historical volatility of the CPI.
An alternative calibration exploiting the currency analogy
One of the difficulties of the previous model is its calibration, which
is based on inflation-linked bond yields (as a proxy for real rates).
In reality, traded inflation-linked bond yields typically contain a
liquidity premium, which is intrinsic to each bond and makes the
calibration tricky. In addition, most inflation-linked bonds (including TIPS) have a redemption floor (see discussion of these issues
in Chapter 9). Inflation swaps do not have these complications. In
fact, an inflation swap is a simple exchange of cashflows at maturity. In addition, inflation swaps are quite liquid and thus widely
used to hedge inflation-structured books. This has led to a change of
risk variables from the triad of nominal rates, real rates and CPI to
the alternative triad of nominal rates, swap BEIs and CPI. The key
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working assumptions are as follows:

swap BEI rates and nominal interest rates are normally distrib-
uted;
the CPI acts as an exchange rate between the nominal and the
real economy.
We refer the reader to the appendix at the end of the chapter for
the pricing formulas of both nominal and real bonds, and also the
relationships linking the old and new set of variables. Note that Brigo
and Mercurio (2006) also introduced a model of both nominal and
real interest rates based on the currency analogy, which is similar to
this one.
Market models of inflation
The inflation derivatives market developed a couple of years after
the seminal model of Jarrow and Yildirim. However, the original
approach was adapted to the TIPS, but some issues emerged in using
this approach for some of these new derivatives instruments, such
as (see, for example, Belgrade et al 2004; Mercurio 2005)
non-observable parameters: inflation rates are derived from
real rates, but the latter are not directly observable from
inflation-linked bonds, for the reasons mentioned earlier,
there is no obvious link between ZCISs and YYISs,
the natural discount curve for the options and swaps is the
Libor curve.
As a result, new inflation models were devised that mirrored the
techniques used in Libor market models, and are based on information from the ZCISs and the YYISs in a consistent way. These models
focused on a set of forward inflation indexes for selected maturities
Ti , i = 1, . . . , N, ie, CPI(t, Ti ) as a lognormal processes under the
risk-neutral probability Q
dCPI(t, Ti )
Q
= (t, Ti ) dt + (t, Ti ) dWi ,
CPI(t, Ti )
i = 1, . . . , N
Different functional choices for the volatility (t, Ti ) can be adopted.

In addition, under the risk-neutral measure, the zero-coupon nominal bond also follows a lognormal process given by
dB(t, T )
Q
= r(t) dt + (t, T ) dWB
B(t, T )
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The model allows for a much richer correlation structure among the
Q
Q
(N + 1) Brownian motions (Wi , i = 1, . . . , N; WB ), than what is
possible in the JarrowYildirim three-factor model.
ZC and YoY payouts can be written in terms of the future price
index levels or, alternatively, in terms of the forward index. For example, a zero-coupon T-maturity payout, be it a swap or an option, is
a function of the ratio
CPI(t, T )
CPI(T0 )
where the denominator has been fixed at trade inception, while the
numerator is unknown before T, and will be determined by the
stochastic evolution of the price index CPI(t). The latter can be written in terms of the stochastic evolution of the forward price index
CPI(t, T ) instead, as the two will coincide at t = T. Pricing instruments based on ZC payouts requires taking the risk-neutral expectations of the discounted terminal payouts. An opportune choice of
numeraire, ie, adopting the T-forward measure, further simplifies
things, as the forward price index CPI(t, T ) is, by construction, a
martingale under such a measure.
Things are a bit more complicated for YoY instruments, where the
terminal payout depends on the ratio of two price index levels, both
unknown at
CPI(t, T2 )
CPI
t < T1 < T2
CPI(T1 );
( T2 )
CPI(t, T1 )
Now there is no clever numeraire choice that can make this ratio a
martingale. In other words, convexity adjustments are unavoidable
when calculating the risk-neutral expectation of the discounted terminal payout. Specifically (neglecting lag effects), these will arise
from the covariance of the two forward price indexes as well as the
covariance of inflation with the nominal discounting entering the
expectation.
As a result, the discounted payment of the YoY(T, T + 1) =
CPI(T + 1)/CPI(T ) 1 must be adjusted for the covariance between
the inflation index at the two different times, as well as the covariance between the forward discount bond B(T, T + 1) and the forward
inflation index.
Mercurio (2005) adopted an alternative market model where both
real and nominal Libor forward rates for a set of maturities Ti , i =
1, . . . , N (thus, 2N Brownian motions) were modelled as lognormal
processes, and inflation derived from these.
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Using these models, we can derive explicit formulas for inflation options that are simpler and more intuitive to calibrate than
those derived within currency-analogy-based models. Indeed, the
advantage of such models is to allow a rich dependence structure
between YoY instruments. This has become important as YoY and
ZC options evolve separately (different players and different flows),
which makes this dependence structure more and more complex. In
addition, it is usually simpler to carry out historical analysis on YoY
data, as there is a relatively long sample which can be used to develop
intuition about the volatility structure (Figures 8.17 and 8.18).
CONCLUSIONS
The inflation swaps market developed on the back of the hedging
activities of pension funds. Although pension funds initially bought
inflation-linked bonds, they readily switched to inflation swaps,
which could be more easily tailored to the specificity of their liabilities. Naturally, an interbank swap market soon developed, for which
the standard became the zero-coupon inflation swap, the structure
of choice of pension funds.
Another important step for the inflation market was the development of inflation-structured notes, which paid coupons linked to the
year-on-year inflation, and were popular among retail investors in
particular. These instruments were key in the development of YoY
inflation swaps and specifically YoY options, as well as an interbank
market for these instruments. In fact, the YoY format is the standard
format for inflation options, although the zero-coupon structure also
trades, with less liquidity. Using the example of inflation swaps, we
showed how it is not straightforward to hedge YoY swaps with ZC
swaps, as one has to take into consideration important convexity
adjustments.
In terms of options, one of the first models was the Jarrow
Yildirim model, which was calibrated using TIPS prices and historical inflation data. This is model was based on the currency analogy, with the inflation index modelled as an exchange rate between
nominal and real bonds. Soon, in part motivated by the YoY option
standard, new approaches came about, which modelled the forward
inflation index in its forward measure (similarly to Libor-market
models) and could be calibrated using inflation and nominal swaps
and YoY inflation options.
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Although this chapter has covered the key developments in inflation market in Europe and the US, inflation instruments (cash and
derivatives) have expanded in other countries as well. Inflationlinked bonds have been issued since the 1960s in some Latin American countries. There is an active inflation-linked bond and swap
market in Australia. Thailand and South Korea have both issued
inflation-linked bonds, and products will keep expanding as their
markets evolve and their pension systems reach financial maturity.
In any case, we expect the stepping stones to be the same: first, the
development of an inflation-linked bond market as the fundamental building block, followed by inflation derivatives, ie, swaps and
possibly options.
APPENDIX
JarrowYildirim currency-analogy-based model
Using the nominal zero-coupon bond as numeraire and its associated probability QN , the dynamics of the prices of the zero-coupon
nominal (N) and real (R) bonds are given by the following equations
(we use a time-decaying volatility model)
dBN (t, T )
N,QN
= rN (t) dt + N (t, T ) dWB (t)
(8.1)
BN (t, T )
dBR (t, T )
R,QN
= (rR (t) R,CPI (t)R (t, T )) dt R (t, T ) dWB (t)
BR (t, T )
(8.2)
x (t, T ) = x (t)
1 exp(x (T t))
(8.3)
The CPI acts as an exchange rate between the nominal and the real
economy
dCPI(t)
CPI,QN
= (rN (t) rR (t)) dt + CPI dWt
CPI(t)
CPI,QN
dWt
N,QN
dWt
CPI,QN
= N,CPI dWt
R,QR
dWt
(8.4)
(8.5)
Alternative calibration of currency-analogy-based model

Using the nominal zero-coupon bond as numeraire and its associated probability QN , the dynamics of the prices of the zero-coupon
nominal (N) bond and the break-even inflation swap (I) are given
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by the following equations

dBN (t, T )
N
= rN (t) dt N (t, T ) dW N,Q (t)
BN (t, T )
dBI (t, T )
N
= ri (t) dt + (t, T ) dt i (t, T ) dW I,Q (t)
BI (t, T )
dCPI(t)
N
= ri (t) dt + CPI dW CPI,Q (t)
CPI(t)
when
x (t, T ) = x (t)
1 ex
x
(8.6)
(8.7)
(8.8)
(8.9)
The change from the old projection into the new projection is based
on the following equations

i = N2 + R2 2N,R N R
N
R
dWti =
dWtN
dWtR
i
i
(8.10)
(8.11)
See Indexed Gilts (Economic Progress Report No. 133), http://www.hm-treasury.gov.uk.
In a defined benefits pension fund, the benefits payable can be a function of several factors,
such as earnings history, years worked and age, but do not depend on the funds investment
returns.
The Japanese case is an exception, as Japan experienced a long deflation period. Note
that Japanese government inflation-linked bonds do not have an embedded inflation floor,
although some banks have structured inflation-linked notes with such a floor.
REFERENCES
Belgrade, N., E. Benhamou and E. Koehler, 2004, A Market Model for Inflation, URL:
ftp://mse.univ-paris1.fr/pub/mse/cahiers2004/B04050.pdf.
Belgrade, N., E. Benhamou and E. Koehler, 2005, Modelling Inflation in Finance,
Inflation-linked Products, Chapter 6 (London: Risk Books).
Bnaben, B. (ed), 2005, Inflation-linked Products (London: Risk Books).
Bnaben, B., and H. Cros, 2008, Global Inflation Derivatives Markets, in Inflation Risks
and Products, Chapter 11 (London: Risk Books).
Bnaben, B., and S. Goldenberg (eds), 2008, Inflation Risk and Products (London: Risk
Books).
Bnaben, B., and N. Tabardel, 2008, Inflation-Linked Options, in Inflation Risk and
Products, Chapter 15 (London: Risk Books).
Brigo, D., and F. Mercurio, 2006, Interest Rate Models: Theory and Practice with Smile, Inflation
and Credit, Part VI, Second Edition (Springer).
Davis, E. P., 2000, Regulation of Private Pensions: A Case Study of the UK, Discussion
Paper PI-0009, The Pensions Institute, URL: http://www.ephilipdavis.com/wp0009.pdf.
174
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European Central Bank, 2000, Seasonal Adjustment of Monetary Aggregates and HICP
for the Euro Area, Aggregates and HICP for the Euro Area, August (Extract).
Jarrow, R., and Y. Yildirim, 2003, Pricing Treasury Inflation Protected Securities and
Related Derivatives using an HJM model, Journal of Financial and Quantitative Analysis
38(2), pp. 337358.
Mercurio, F., 2005, Pricing Inflation-Indexed Derivatives, Quantitative Finance 5, pp. 289
302.
Mercurio, F., and N. Moreni, 2006, Inflation with a Smile, Risk, March, p. 70.
Peng, W., 2006, Understanding Inflation Convexity, IXIS Capital Markets, URL: http://
inflationinfo.com/CPICvx.pdf.
Taylor, J. B., 1993, Discretion versus Policy Rules in Practice, Carnegie-Rochester Conference
Series on Public Policy, Volume 39, pp. 195214 (Elsevier).
Wilson Committee, 1980, Report of the Committee to Review the Functioning of Financial
Institutions (Chairman Sir Harold Wilson), Command Paper 7937 (London: HMSO).
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Part II
Research and Macro

Perspective
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The Role of Models in Modern

Monetary Policy
Stefania A. Perrucci and David Vavra

New Sky Capital; OGResearch
The objective of most central banks is to maintain price stability

while promoting stable economic growth and employment. To this
end, central banks adopt a systematic approach, ie, a monetary policy regime, which typically differs from country to country. Since
the early 1990s, inflation targeting (IT) has been part of the monetary policy regime of many central banks, contributing credibility
to their efforts, and helping to keep inflation under control in many
countries for the following two decades. In IT regimes, the main
focus is on the interest rate/monetary policy instrument path that is
consistent with keeping inflation within range, or bringing inflation
back to target.
In this chapter, we examine the types of model central banks build,
and how they operate them. Usually, central banks maintain a whole
suite of models, referred to as a forecasting and policy analysis system (FPAS). These models have different capabilities, with statistical/empirical models typically employed for short-term analysis
and structural/behavioural models used for longer-term horizons.
We describe the different components of an FPAS, including the central core model, the models used to determine initial conditions, the
ways in which exogenous variables enter the forecasting process and
the judgemental inputs that might be used along the way.
Finally, we discuss how FPASs are used in practice. Simply put,
macroeconomic forecasts are never perfect, but, despite their limitations, models provide an important tool, assisting central banks in
making the best policy decisions under unavoidable uncertainty.
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MODELS AND MONETARY POLICY

The legal mandate of most of the central banks at the time of writing
is maintaining price stability (which is usually the overriding goal)
while avoiding instabilities in real economic activity and employment (which is usually a secondary goal subordinate to price stability, although this is not true in all countries, as we shall see
shortly).
To achieve its goals, every central bank chooses its mode of operation, ie, a monetary policy regime. Traditional monetary policy
regimes include various forms of exchange rate management (a peg,
a crawling peg or a band) or monetary targeting. Another traditional
option is a so-called eclectic mix. Under the traditional regimes, central banks adopt an operational or intermediate variable (the spot
exchange rate against a particular currency, or year-on-year growth
in a particular monetary aggregate) and set and manage targets for
this operational variable with the aim of maintaining price stability. Although the links between such intermediate targets and price
stability are neither clear nor necessarily stable and predictable,
these operational targets are under more or less direct control of
the central bank. As a consequence, the central banks under these
regimes devote most of their analytical capacity to designing their
operations (such as foreign exchange interventions or local money
supply procedures) to meet the set intermediate targets efficiently.
Broader macroeconomic analysis plays a rather secondary role, simply because it is out of the scope of the banks core business; when
conducted, the analysis is often dominated by a very short-term
outlook and in-depth sectorial detail.
In the early 1990s, a brand new approach to monetary policy
emerged: inflation targeting. Invented and first implemented by the
Reserve Bank of New Zealand in 1990, it quickly spread into many
other countries, both advanced economies and emerging markets.
At the time of writing, the number of IT central banks stands at a
few dozen, with a single abandoner so far,1 not including those that
joined the eurozone as abandoners for obvious reasons.
What is different about IT?2 First, intermediate targets are abandoned and the central banks attention is focused directly on price
stability (and other secondary goals as applicable). Second, IT tends
to involve more active management, especially when a big price
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THE ROLE OF MODELS IN MODERN MONETARY POLICY
Figure 9.1 Reserve Bank of New Zealand 90-day interest rate forecast
Projection
Ninety-day interest rate (%)
10
9
8
7
6
June MPS
5
4
Central
3
2
1
0
2004
2006
2008
2010
2012
Source: Reserve Bank of New Zealand.
shock occurs. Third, IT is more transparent and consistent, as monetary policy is committed to targeting a specific price level or range
of price levels. Typically, the specific target is set in terms of the
headline Consumer Price Index (CPI) or core CPI, or the headline
or core Personal Consumption Expenditure (PCE) prices index. The
target itself is most often set not by the central bank alone, but rather
by the government or by agreement by both. The central bank then
commits to using available policy instruments (almost exclusively
the short-term interest rate, such as the two-week repo) to respond
to economic shocks and induce inflation to return to target over a
medium run.3
The success of IT hinges on the capacity of the central bank to react
with the appropriate policy instrument to developments expected
in the future. Todays actions have to ensure that inflation returns to
the target level at a given horizon, given the most plausible assumptions. In doing so, small short-term disturbances are often ignored,
as the focus is on the medium-to-long-term risk of inflation. Obviously, this requires a good understanding of policy transmission and
its lags (which typically range between four and eight quarters, ie,
one to two years). Such a task puts enormous pressure on forecasting capacity, and on the ability to make decisions under uncertainty.
Almost any central bank produces various kinds of economic forecasts, but many use them only as an indicative macroeconomic outlook and in conjunction with several other inputs. By contrast, in an
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Figure 9.2 Swedens Riksbank repo rate forecast with confidence

bands (in percent)
8
90%
75%
50%
6
5
4
3
2
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
Source: Swedens Riksbank.
Figure 9.3 Norges Bank policy rate forecast and confidence bands (in
percent)
9
8
30%
50%
70%
90%
7
6
5
4
3
2
1
0
2008
2009
2010
2011
2012
2013
2014
Source: Norges Bank.
IT regime, forecasts become an essential backbone for the decisionmaking process. Furthermore, there is an intricate complexity about
these forecasts. Their main focus is typically not directly on inflation but on the trajectory of interest rates. If you look at the inflation
forecast charts that IT central banks produce every quarter, you will
note that it is not a very interesting chart: inflation always returns to
the target level sooner or later. The more important chart shows the
trajectory of interest rates that is consistent with this inflation profile,
ie, the trajectory consistent with bringing inflation to target under
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Figure 9.4 Czech National Bank three-month Pribor rate forecast and
confidence bands (in percent)
5
90%
70%
50%
30%
4
3
2
2009 Q3
2009 Q4
2010 Q1
2010 Q2
2010 Q3
2010 Q4
2011 Q1
2011 Q2
2011 Q3
2011 Q4
2012 Q1
2012 Q2
2012 Q3
2012 Q4
2013 Q1
Source: Czech National Bank.
Figure 9.5 Bank of Israel interest rate forecast and confidence bands
(percentage)
7
6
5
4
3
2
1
0
2010
2011
2012
Source: Bank of Israel.
most plausible assumptions. At the time of writing in spring 2012,

at least five central banks (the Reserve Bank of New Zealand, Swedens Riksbank, Norges Bank, Czech National Bank and the Bank
of Israel) publish their quarterly forecasts together with the future
projections for their own policy rates (and, with the exception of
the Bank of Israel, also projections for their exchange rates), while
most other IT central banks work with such interest rate trajectories
internally for policy decisions (Figures 9.19.5).
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What do these interest rate trajectories mean? First, for an IT

central banks forecast to make sense, it must have a particular path
for the monetary policy instrument built into it, and the policy rate
path must obviously be consistent with the rest of the forecast. Second, the fact that the four central banks publish future short-term
interest rates and exchange rates does not, by any means, imply
commitment to these paths. The projections are instead conditional
statements: given the information on the state of the economy available at the time, this is the most likely course of monetary policy in
the future. And, remarkably, thanks to the clear long-term communication strategies of these banks, aided greatly by their model-based
analytical frameworks, market analysts, investors and the general
public have come to understand very quickly in these countries
what message these conditional statements convey. Constructing
such an interest rate trajectory is not possible without a fairly elaborate and model-based forecasting system. This is exactly why central
banks started developing new types of model, ie, models that tell us
something about the medium-term forces driving inflation and other
macroeconomic variables, provide key insights and facilitate coherent narratives, and allow true policy analysis. Short-term outlooks,
detailed information and very accurate statistical properties might
be still useful, but they are neither a sufficient nor the most essential
input into policymaking.
Are models all that there is to it? Certainly not, as monetary policy
analysis, economic forecasts and human judgement will always be
crucial factors. But models are of great help to the policymaker. When
built and used properly (and this is a crucial qualification), models
help central bank staff to process a large amount of information in a
consistent way and to draw logical conclusions. Most importantly,
the use of models increases transparency and encourages communication about policy issues, both inside and outside the central bank.
The implications of various risk factors, costs of policy errors and
changes in forecasts from quarter to quarter can quickly be analysed
using a model. This greatly facilitates openness, and thus strengthens policy credibility. Thus, by facilitating policy debates, modelbased forecasting systems help central bankers to be transparent,
predictable and accountable: crucial elements of success for an IT
central bank. Indeed, if people understand what the central bank
is doing now and will do next (transparency and predictability),
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why the bank is doing it and how the bank learns from its own
mistakes (accountability), it is much easier to affect and ultimately
anchor expectations on the inflation target. In turn, if expectations
are anchored, then the actual outcomes will become more favourable
and stable.
This new approach to policy making could not be in a starker
contrast with the older paradigm. In the past, monetary policy was
believed to be most efficient if it was based on unexpected surprises
(in fact, there is still a relatively large amount of academic research
nowadays that finds the so-called money supply shocks the proper
monetary policy tool to investigate), and assumptions about systematic behaviour of policy rates had no role in economic projections.
There also seems to be a widening gap between the practices of
banks that have an explicit inflation target and those who do not,
most notably the central banks behind the two major currencies: the
European Central Bank and the US Federal Reserve System. It is hard
to believe that the first ever press conference by the US Feds Chairman occurred only in April 2011, and documents explaining the Fed
staff projections were only released with a six-year lag, until the decision to make forecasts available to the public in January 2012. Until
then, the US Fed communication strategy had been in sharp contrast
with one of the other central banks, for which making regular public
appearances, publishing full-fledged reports immediately after policymaking meetings and posting models and other analytical tools
on websites had been routine practice for a long time. There can be
no wonder that markets were very surprised and rather confused to
hear Ben Bernanke say in his press release4 that
economic conditions are likely to warrant exceptionally low
levels for the federal funds rate for an extended period.
Because it was not properly explained, and such a statement had

never been heard before, it was, unsurprisingly, considered by
many as an unconditional commitment, and provoked considerable
controversy.
The ECB appears to be somewhat closer to accepted best practice,
having an explicit inflation objective of 2% in the rate of change in
the Harmonized Index of Consumer Prices (HICP), the eurozones
aggregate measure of inflation. However, the ECB resists defining
itself as exclusively an inflation targeter (an interesting reading is
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Issing 2008). Instead, the bank relies officially upon a so-called twopillar strategy, consisting of economic analysis and monetary
analysis. This gives its policy a traditional money-targeting flavour
to some extent. The ECB staff finds, nevertheless,
the assumptions about short-term interest rates [to be] of a purely
technical nature.
(European Central Bank 2011)
FORECASTING AND POLICY ANALYSIS SYSTEMS

Given how useful macroeconomic models have proven to be in modern monetary policymaking, we now turn to the question of what
models central banks build, and how exactly they operate them. First
of all, even though the whole point of building models is to improve
the ability to combine all the pieces of available information in a consistent manner, common and best practice is actually not to have one
universal model of everything, ie, covering every possible aspect of
the economy. This is mainly because models (and macroeconomic
models in particular) are not meant to capture the whole universe
of economic phenomena at once, but should help in gaining specific
insights and provide better understanding of the economy. Not only
do overly complex and detailed models get rather impractical from
an operational point of view, but their ability to tell understandable stories quickly diminishes as complexity increases. In addition,
when a models level of detail becomes overwhelming, both central bank staff and end users (ie, policymakers) have the tendency
to fine-tune various trivialities,5 while not attending sufficiently to
broad-picture issues that are of first-order importance.
Typically, central banks maintain a whole suite of models and
other tools, each with a clearly defined role, and design processes
to combine the strengths of the individual models, to make effective
use of all information available at a given time and to make sure that
the final product is not a simply mechanical model forecast. Such a
collection of models and processes is referred to as a forecasting
and policy analysis system. Most of the models within the suite are
built to complement one another, including providing alternative
or competing views on the same matter. We shall now describe the
different models typically found in an FPAS, and explain the most
common steps during the forecasting process.
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Reliability
(prediction power)
Figure 9.6 Different forecasting horizon and models

Reduced-form
(empirical, statistical)
models
Short term
Medium term
Projection horizon
Different models for different forecasting horizons

The structure of many of the model-based systems existing in central
banks is based on the observation that different methods are suitable
for different things. This is perhaps most evident when we look
at the forecasting horizons applicable to different types of model.
Figure 9.6 illustrates the point, showing how statistical models tend
to have better prediction power for short horizons, while structural
models tend to outperform over medium forecasting horizons.6
In the short term (more below on how this is defined in practice), macroeconomic forecasting is best done by describing idiosyncratic developments, exploring empirical correlations and accumulating detailed expert knowledge of individual sectors and industries. Short-term (also known as near-term) projections for output
or inflation based on the proximate causes of their movements more
often than not outperform those relying on macroeconomic fundamentals by a great margin. On top of that, monetary policy has little
effect within such a short span of time, perhaps with the only exception of the nominal exchange rate, so that central banks policy is
usually not an input to short-term forecasts.
In the medium term, though, monetary policy actions, peoples
expectations and behavioural mechanisms7 become the dominating forces in economic projections. Attempts to exploit observed
reduced-form relationships (ie, statistical relationships between
endogenous and exogenous variables) without references to sound
economic theories can easily hide some critical trade-offs, and hence
drive the policymakers into dangerous waters. Real-world examples
include the neglect of inflation expectations in the 1970s, and the
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Initial conditions
External
projections
Nowcasts and
near-term
forecasts
Trend-cycle
analysis
Trend
assumptions
Core
projection
model
Satellite
models
Informal
judgement
Judgemental adjustments
Figure 9.7 Major components in an FPAS model
role of loose monetary policies in changing risk perception during

the Great Moderation in the 1990s.
Finally, long-term real (as opposed to nominal) trends are viewed
as largely immune to the way monetary policies are conducted
(although, for instance, broad consensus exists on the real benefits of
low and stable inflation), while monetary aspects (such as inflation)
are, on the contrary, under full command of the central bank, at least
in theory.
The specific definition of what constitutes a short-term versus
a medium- or long-term forecasting horizon depends on the structural characteristics of each economy. Typically, a short-term forecast
might span a few months or quarters ahead, a medium-term forecast
covers a horizon up to four or five years and a long-term forecast
extends to any term beyond that. Note also that the definition of
a short-, medium- or long-term horizon varies considerably across
different fields of economics.
Major components of an FPAS model
An FPAS is organised around a core projection model. The model is
used as a platform to integrate three types of inputs coming from
outside that model: initial conditions, exogenous projections and
judgemental adjustments (Figure 9.7).
The core projection model is the backbone of the FPAS and
the whole forecast production process. It is a structural or semistructural business-cycle model describing the main medium-term
propagation mechanisms (or transmission channels). The core projection model instills discipline into the forecasting process, while
providing a consistent, unified language for both central bank staff
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and policymakers. Given that the model is used to guide the policymaking process itself, this would seem to imply that monetary policy
and expectations are exogenous to it. Yet, a considerable number of
central banks, including some in advanced economies, still struggle
to understand how crucial an assumption this is for good conduct
of their policies. These issues will be discussed in greater detail in
the next section.
Models for the so-called now-casts deliver estimates for the current month or current quarter of those variables that are not yet
available due to a publication lag. Techniques used in now-casting
are basically the same as in near-term forecasting, which produces
a very short-term outlook for the main variables, say a quarter or
two quarters ahead. These numbers are then commonly treated as
hard data when entered into the core projection model (effectively
extending the actual time-series observations). Most of the central
banks combine two basic approaches to constructing now-casts and
near-term forecasts (NTFs): expert knowledge-based projections and
reduced-form multivariate time-series models. In both, the estimates
and forecasts are built bottom-up using an extensive number
of detailed macroeconomic indicators (most of which do not even
appear in the core projection models).8 The multivariate reducedform models include various sorts of estimated vector autoregressions (VARs) adjusted to deal with the problem of potential overfitting, such as Bayesian vector autoregressions (BVARs) or factoraugmented vector autoregressions (FAVARs); see the appendix on
page 201 for a brief explanation of these two techniques.
Trend-cycle analysis9 is needed because the core projection models are frequently built around economic concepts (such as equilibrium values) that are not directly observable: two examples are the
output gap (or, equivalently, potential output) and the natural rate
of interest. Trend-cycle analysis is therefore necessary for setting up
the initial conditions for the model. Broadly speaking, there are three
options available.
1. Univariate filters, which produce more or less mechanical
results with the option of judgemental adjustments. These
include the popular Leser (1961) filter, also known as the
Hodrick and Prescott (1997) filter in economics.
2. Various multivariate filters relating the trends and cycles in the
variable(s) in question to other indicators that are expected to
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co-move with them; consider, for example, using the data on

capacity utilisation to inform the estimates of the output gap,
see, for example, Benes et al (2009) for an example of such filter.
3. So-called model-consistent estimation of the unobservable
quantities, where the core projection model itself is used to
calculate the decomposition of output, real rates or other variables into their trends and cycles (gaps). However appealing
it may be, this technique requires a relatively high level of
sophistication; not all core projection models are suitable for,
or even capable of, this job.
Related to trend-cycle analysis are trend projections. As the core
projection models usually have a very stylised block (or simply no
such block) describing the long-term evolution of actual trends (eg,
potential output, labour productivity, productive capacity), the realism in the trend projections is achieved by supplying judgementally adjusted assumptions. These assumptions are the result of a
broader discussion among the bank staff, aided sometimes by simple growth models (as opposed to business-cycle models used as the
core projection tools).
External or other exogenous projections are simply trajectories for
those variables that the model takes as given. For instance, in models
of small, open economies like the five aforementioned IT countries
(New Zealand, Sweden, Norway, Czech Republic and Israel), it is
foreign output, foreign inflation, foreign interest rates or the terms
of trade that need to be predicted. Furthermore, the exogenous projections may also include various fiscal outlooks, the price of oil or
other commodities, paths for administered prices in countries with
government regulation of some sectors and so on.
Finally, there is an important category of satellite models. These
models are meant to flesh out the sectors that are (too) simplified in
the core projection model, or absent from it, but might occasionally
prove important for the overall macroeconomic developments. Typical candidates are fiscal considerations/assumptions, the banking
sector and labour markets. Furthermore, satellite models may also
offer alternative views on the workings of monetary policy transmission, or examine the implications of various non-linearities that
would be operationally difficult to incorporate directly into one of
the forecast production models.10
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All these diverse and conceptually different inputs need to be

combined in a single baseline projection, plus a small number of
alternative scenarios. The core model and its software infrastructure
must therefore be flexible enough to allow simulations with various types of conditioning information and judgemental adjustments
incorporated in them.11
The forecast production process
In most countries, the forecast production process has a quarterly
cycle. Although the policymakers usually meet more frequently, typically every six or eight weeks (with the meetings disguised under
a variety of names, such as bank board meeting, monetary policy committee, Federal Open Market Committee (FOMC) meeting),
there would not be a sufficient amount of new information to run
a fully fledged forecast with a higher frequency. The limiting factor
is perhaps the availability of national accounts data, ie, GDP and
its components, which are the main indicators of the countrys real
economic activity.
A typical forecast production exercise takes roughly four to six
weeks and several rounds of meetings to complete, depending on
the factors discussed below. It is generally scheduled so as to comply
with two requirements: it be a timely, up-to-date input into one of the
policymaking meetings; the key data releases, which are inflation
and GDP, occur somewhere in the middle of the production. The
standard practice of the leading central banks is that the forecast
package submitted by staff to the policymakers contains (at least):
a baseline projection together with a clear and consistent nar-
rative;
policy recommendations consistent with, and incorporated in,
the baseline projection;

alternative scenarios, including alternative policy paths;
an assessment of uncertainty (prediction intervals);
an explanation of what factors caused a change in the baseline
compared with the previous one.

How much attention do policymakers pay to such a forecasting package in their decision-making? And how much of this package is
made public? The trend at the time of writing has been towards
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making clear who in fact owns the forecast (in other words, whether
it expresses staff views or policymakers views) and its weight in
the decision-making. Obviously, the ownership of the forecast also
influences the forecasting process itself. If it is to be a policymakers
forecast, the production will almost surely take longer, as the central bank staff needs to meet with the policymakers more frequently,
and eventually fine-tune the results to their liking. Indeed, at some
central banks, there are two distinct forecasting rounds: the first produces projections based on staff views, while the second incorporates
policymakers assumptions and judgement. When it comes to the
issue of forecast ownership and the weight that forecasting has on
policy, different central banks take different approaches, which are
clear for some and more ambiguous for others. A few examples are
listed below.
The Bank of Canadas Monetary Policy Report, July 2011,
states: This is a report of the Governing Council of the Bank

of Canada.
The Bank of Englands Inflation Report, August 2011, states:
The Inflation Report is produced quarterly by Bank staff

under the guidance of the members of the Monetary Policy
Committee. It serves two purposes. First, its preparation provides a comprehensive and forward-looking framework for
discussion among MPC members as an aid to our decisionmaking. Second, its publication allows us to share our thinking and explain the reasons for our decisions to those whom
they affect. Although not every member will agree with every
assumption.
The Riksbanks Monetary Policy Report, July 2011, states: The
report describes the deliberations made by the Riksbank when

deciding what would be an appropriate monetary policy.
The Executive Board decided to adopt the Monetary Policy
Report at its meeting on 4 July 2011.
The Czech National Banks Inflation Report, 2011 Q3, states:
The forecast for the Czech economy is drawn up by the CNBs

Monetary and Statistics Department. The forecast is the key,
but not the only, input to the Bank Boards decision-making.
The Reserve Bank of New Zealands Monetary Policy State-
ment is directly signed off by the Governor.

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The ECB Staff Macroeconomic Projections for the Euro Area
states: The ECB staff macroeconomic projections complement

the Euro system staff macroeconomic projections that are produced jointly by experts from the ECB and from the euro area
national central banks on a biannual basis (European Central
Bank 2011). It is not clear from the document what role it plays
in the ECBs policy decision-making.
The US Federal Reserve System used only to publish a one-
page summary of the views of board members and regional

bank presidents on four macroeconomic variables (GDP, unemployment, inflation and core inflation). The release of more
detailed projections, including what the Fed funds rate should
look like in the future, without further shocks to the economy,
started only in January 2012.12
CORE PROJECTION MODELS
As we stated in the previous section, a core projection model is the
focal point of the forecast production process because it combines all
inputs into a coherent scenario; it imposes discipline to both internal and external communication of central banks and allows the
running of alternative scenarios with consistent policy implications.
Understandably, its design, development and implementation are
usually a lengthy and intellectually challenging undertaking, which
typically adheres to the following principles.
Parsimony: core projection models are kept rather simple, as
they need to be understandable and useful in providing key

insights to its operators. Core models also need to gain acceptance and some sort of intellectual ownership across the entire
institution, including non-modellers and senior management.
This would be impossible to achieve with a high degree of
complexity and mathematical abstraction.
Top-down approach: monetary policy is primarily about the
broad picture, not about fine-tuning. The first step in designing

core projection models is the identification of a set of key policy
properties, while any further disaggregation and finer sectorial
detail are subordinate to those properties. Some of the common
policy properties embedded in models are the following.
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Long-term neutrality. Real outcomes (as opposed to monetary, or nominal, variables) remain unaffected by monetary policies in the long run (unless the policies are very
bad) and, vice versa, the central bank can set and achieve
any inflation target (or other nominal, or monetary, target)
without distorting real outcomes. In practice, of course,
the neutrality is a convenient assumption only within a
range of relatively low and stable inflation rates.
Medium-term real effects of monetary policy. Unlike in
the long run, the central banks actions do impact on real
outcomes in the medium run, thanks to various types
of frictions and rigidities (such as price and wage stickiness). These rigidities wear off after a sufficiently long
time, allowing neutrality to reign again.
The stabilising role of monetary policy throughout the
business cycle. The systematic reaction of the central bank
to macroeconomic shocks must be sufficient to prevent an
inflation (or deflation) spiral. For example, an inflation
spiral occurs whenever high inflation, not fought against
by the central bank, feeds into expectations, thus reducing
real rates and raising demand. Excess demand adds more
pressure still on inflation, and the economy is caught in a
vicious circle.
Forward-looking expectations. Although it would be
unrealistic to assume fully forward-looking expectations
in practical applications, the rational element in expectations must not be neglected. Otherwise, the model-based
advice could easily make the policymakers believe they
could exploit permanent trade-offs where there are none;
in other words, the model would imply the central bank
could fool all of the people all of the time.
Robustness to policy errors: the predictive power of core pro-
jection models is often defined by their ability to get the timing of the turning points in a business cycle right. This proves
more important than any other statistical test. Accurate turning points are one of the preconditions for avoiding systematic policy mistakes: such as type A policy errors (being too
ahead of the curve, ie, reacting to false signals) or type B
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policy errors (being behind the curve, ie, not reacting to true
signals).
Different types of core projection models
We can identify four broad varieties of core projection models:
1. large-scale econometric models;
2. weak-form dynamic stochastic general equilibrium (DSGE)
models;
3. semi-structural flow (or gap) models; and
4. semi-structural stock-flow models.
Large-scale econometric models are considered to be outdated in
the context of monetary policy models (which is not to say they are
useless, but that they are not the right model for monetary policy).
They are usually designed bottom-up, with great emphasis on disaggregation; they also most often lack an explicit role for monetary
policy or expectations, with the notable exception of the US Federal
Reserve staffs model.13 Because they are estimated without proper
monetary policy, they tend to incorrectly interpret various monetary
stabilities or instabilities observed in the data.
The other three types of model are generally much more compatible with modern monetary policymaking. There exists, though,
a certain trade-off between operational simplicity and theoretical
coherence across those three varieties. We now briefly explain some
of their defining features.
DSGE models start by making explicit and detailed assumptions
about what types of economic agent act in the model economy (such
as households, producers, retailers, banks, the central bank and government), what their objectives are (to maximise utility or profits)
and the environment in which they interact (eg, competitive markets,
monopolistic markets). Then, they derive the optimality conditions
for the behaviour of each, aggregate these over the entire economy
and impose general equilibrium conditions (ie, that demand equals
supply in each market at the prevailing price). However appealing the concept of a DSGE is, it is in practice impossible to build
DSGEs that perform well in all the desired empirical dimensions
while keeping all the underlying assumptions about the agents
objectives strictly consistent with microeconomic and behavioural
theories. Therefore, various shortcuts, simplifications and ad hoc
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additions are introduced when setting up the optimisation problems

solved by the models agents. This is why virtually all practical policy DSGEs are of a weak-form variety (as opposed to strong-form
DSGEs, which do adhere to rigorous microeconomic foundations: a
distinction proposed by Faust (2009)).
The first central bank to announce the official use of a DSGE
model in its forecast production was the Bank of England in 2004
(BEQM). Several other banks have followed since: Bank of Canada
(ToTEM), Reserve Bank of New Zealand (KITT), Bank of Finland
(Aino), Norges Bank (NEMO), Riksbank (RAMSES), Czech National
Bank (G3) and others.14 These models are (without exception) publicly available from the websites of the respective central banks.
Note also that there are many more central banks using DSGEs for
research or occasional analysis, but not specifically relying on them
from official forecast production.
The semi-structural models apply higher levels of ad hoc adjustments still. Their equations do somehow loosely map into weakform micro-foundations, but to achieve realistic dynamics and
explain the observed data characteristics it is the final equations
that are modified rather than the underlying optimisation problem. An example of a stylised semi-structural model is given in the
appendix on page 202. Semi-structural models include both so-called
flow models and stock-flow models. Flow models either ignore or
treat stock variables (eg, productive capital, foreign or public debt,
and balance sheets) as exogenous, and only deal with flow variables (such as output, imports and expenditures). Stock-flow models, on the other hand, keep track of stock-flow consistencies, such as
how investment expenditures increase productive capacity in a certain industry, or how current account deficits result in foreign debt
deterioration. Stock-flow models not only have greater operational
complexity but are also more difficult to implement because of practical limitations in the empirical data needed to measure stock-flow
relationships.15
Policy reaction function
As mentioned before, if the baseline projection is to depict the most
likely scenario, the way the central bank systematically responds
to risks to inflation or output must be an endogenous part of the
model; a formal description of the systematic behaviour of a central
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bank is also known as a policy reaction function or a policy rule. The

case for incorporating an endogenous policy rule in central bank
projections is stronger still if we consider that the policy rule is (at
least conceptually) rooted in markets expectations, in one way or
another. No one certainly believes that the central bankers will sit on
their hands when inflation is getting a push. Therefore, a forecast or
policy advice based on the assumption of the policy rates being constant no matter what has next to no value. Perhaps even worse than
a constant policy rate assumption, some banks, including the Bank
of England, make the policy rate follow the path implied by market
expectations (constructed, for instance, from a yield curve or the forward rate market). In that way, the bank effectively gives up on its
role as a market expectations leader and becomes a follower, exposing itself to the potentially fatal risk of falling consistently behind
the curve.
The experience of several central banks, on the other hand, is that,
if communicated properly, the policy rule assumptions made in the
projections will be quickly understood and learned by the markets.
The benefit of this is clear on both sides: the movements in the yield
curve are likely to become more predictable (a desirable feature from
the policy point of view), making the central banks job easier to
accomplish.
What form do endogenous policy rules take in projections models? With a very few exceptions, central bankers prefer to use simple
rules, such as that proposed by Taylor (1993), or rather its forwardlooking variation as detailed in the appendix on page 202. Simple
rules try to describe the central banks policy reaction function using
a limited number of key variables. A Taylor-type rule usually sees
the interest rate react to deviations in inflation, or model-consistent
inflation forecast, from the target, and to some measure of real economic activity, such as the output gap. Furthermore, the rules are
constructed so as to avoid rapid swings in the policy rate settings
in response to new, potentially noisy and uncertain information (socalled policy smoothing); this is why we typically see autoregressive terms in the equations describing the policy reaction function
of central banks. These simple rules have two great advantages:
1. they are very easy to communicate within the central bank and
to the public;
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2. they are relatively robust across different models, delivering

good performance (see, for example, Taylor 1998).
In comparison, at least one central bank, Norges Bank, adopts a
different approach by applying an optimal rule, based on minimising
an explicit loss function, to model its policy reaction function (see
Norges Bank (2011) for details).
HOW MODELS ARE USED
Macroeconomic forecasts are never perfect, and in practice projections are wrong most often than not. Any policymaker is aware of the
limitations in models given their reliance on a multitude of assumptions and the inherent nature of the forecasting process. This said, the
forecasting exercise should help a central banker in making the best
decisions under unavoidable uncertainty. This implies that forecasting accuracy is not as important as the ability to consistently differentiate between alternative future developments. Furthermore, the
forecasting system helps to collect the right information, organise
it properly and, most importantly, analyse the nature of economic
shocks in order to assist policymakers in their functions. For instance,
Figure 9.8 shows how a model-based analysis of inflation data is able
to dissect its underlying causes. With this information, policymakers may choose to ignore a rise in inflation if driven by a temporary
supply side shock, even if inflation exceeds the target. Clearly, if the
rise in inflation were due to a demand shock or a dis-anchoring of
inflation expectation, the policy response might be quite different.
In addition, a model-based FPAS is able to identify the optimal
policy response in any specific simulated scenario. For instance, if
the above supply shock proved to be a permanent one, the correct
policy response can be inferred within the model. Clearly, the model
itself does not necessarily provide much insight on whether a specific
future scenario is more likely than any other, as this is a judgement
call left to the policymaker. However, a model-based analysis can
offer a comparative view of the different outcomes, including the
optimal responses in each circumstance, as well as the implications of
making the wrong economic assumptions. Thus, even if some degree
of uncertainty cannot be avoided, the overall process is helpful to
the policymaker in choosing the appropriate strategy.
As an example, Figure 9.9 shows the change in an interest rate forecast due to different effects, specifically a change in model (labelled
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Figure 9.8 Inflation contributions from different underlying drivers

30
25
20
15
Supply shock
Imported inflation
Inflation expectations
Demand and others
Initial conditions
10
5
0
5
10
20
2005 Q1
2005 Q2
2005 Q3
2005 Q4
2006 Q1
2006 Q2
2006 Q3
2006 Q4
2007 Q1
2007 Q2
2007 Q3
2007 Q4
2008 Q1
2008 Q2
2008 Q3
2008 Q4
2009 Q1
2009 Q2
2009 Q3
2009 Q4
2010 Q1
2010 Q2
2010 Q3
2010 Q4
2011 Q1
15
Source: OGResearch.
model change in Figure 9.9), new data/assumptions (labelled

combined effect of new data) and a change in forecasting horizon (labelled data coverage change). We can see that the model
change is the main driver for the downward forecast revision in the
medium term, while new data and assumptions pull the forecast
down in the short term.
As another example, Figure 9.10 shows the effect that a rise in
world food prices would have on the baseline inflation forecast and
real GDP. This type of analysis helps in determining the sensitivities
inherent in policymaking, and also in more effective communication
among bank staff and with the general public.
To conclude, an FPAS provides a disciplined approach and guides
policymakers in setting policy in a way that is consistent with the
declared objectives, thus positively affecting its credibility.
CONCLUSIONS
In this chapter, we discussed the forecasting processes used by
policymakers and argued that, despite their intrinsic limitations,
models are a useful tool in guiding the decision-making process of
central banks. Specifically, although a model-based analysis cannot
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Figure 9.9 Drivers of change in interest rate forecast

Model change
Data coverage change
Combined effect of new data
0.5
0
0.5
0.10
0.15
0.25
2012 Q1
2012 Q2
2012 Q3
2012 Q4
2013 Q1
2013 Q2
2013 Q3
2013 Q4
2014 Q1
2014 Q2
2014 Q3
2014 Q4
2015 Q1
2015 Q2
2015 Q3
2015 Q4
2016 Q1
2016 Q2
2016 Q3
2016 Q4
0.20
Source: OGResearch.
eliminate the inherent uncertainties in the forecasting process, it can

offer a comparative view of the different outcomes, including the
optimal responses in each circumstance, as well as the implications
of making the wrong economic assumptions.
After the 20089 financial crisis, some people highlighted the failures of policymakers, and their models, in not being able to foresee the impending disastrous events, and thus mitigate their effect.
However, if failure it was, it was not models the that were to blame,
but imperfect foresight and judgement on behalf of the users of those
models, ie, policymakers themselves. In fact, a model will never be
capable of predicting a crisis, although it might provide clues about
the possible triggers. It is up to the users to feed in the relevant scenarios, including possible adverse shocks and other inputs, and let
the model reveal the implications. There are clearly lessons to be
learnt from the financial crisis, in particular regarding the important
feedback effects between the overall economy and the financial sector. Indeed, adding a model component to address macro-financial
linkages, even if simple and stylised (see, for example, Carabiencov et al 2008), might be helpful, as it provides one more point at
which a crisis can possibly originate. However, at the core, it will
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Figure 9.10 Change in (a) baseline inflation and (b) real GDP forecast
due to a food price shock
(a)
14
Baseline
YoY inflation (%)
12
Scenario
10
8
6
4
2
0
2007 2008 2009 2010 2011 2012 2013 2014 2015
(b)
Real YoY GDP growth (%)
20
15
10
5
0
5
Baseline
10
Scenario
15
20
25
2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
Source: OGResearch.
always be up to the analysts judgement to create the relevant scenarios and, in conjunction with all the available quantitative and
qualitative information, determine the best policy action path going
forward.
APPENDIX: MULTIVARIATE MODELS FOR NEAR-TERM
FORECASTING
In this appendix, we outline the methodology of Bayesian vector
autoregressions and factor-augmented vector autoregressions. Both
of these methodologies were developed specifically to deal with
empirical short-term dynamic relationships between a (potentially
very) large number of variables. Empirical models with a very large
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number of variables are always prone to over-fitting: put simply,

there are not sufficient degrees of freedom to get reliable and robust
estimates of the model parameters.
The BVARs are vector autoregressions in their simplest form, ie
xt = A1 xt1 + + Ak xtk + t
where xt is an N 1 vector of observations at time t (with the
size of the vector potentially very large), A1 , . . . , Ak are parameter matrices to be estimated and t is a vector of forecast errors.
To achieve an acceptable level of identification, we first construct
so-called priors for the parameter matrices; most often these are
simplistic assumptions about the individual variables. For example, if our prior is that all variables are random walks, we choose
A1 = 1, A2 = = Ak = 0, and assign a certain weight to our
k can then be thought of as a
1, . . . , A
priors. The final estimates, A
weighted average of the priors and the unrestricted estimates we
would obtain by estimating the system using classical methods.
FAVARs, on the other hand, deal with the identification problem
in a different way. We estimate a small number of so-called common
factors, ft , that drive most of the dynamics in the observed series, and
then estimate a classical vector autoregression (VAR) on the factors
only
xt = C f t + t
(9.1)
ft = A1 ft1 + + Ak ftk + t
(9.2)
Equation 9.1 links the endogenous variables to a K 1 vector of

factors, where the number of factors, K, is considerably smaller than
the number of the original variables, N. Furthermore, t is a vector
of the so-called idiosyncratic prediction errors, while t is a vector
of factor prediction errors.
There are numerous applications of the two methodologies in central bank forecasting; two examples are Banbura et al (2008) and
Bernanke et al (2005).
APPENDIX: AN EXAMPLE OF A STYLISED
SEMI-STRUCTURAL FLOW MODEL FOR AN OPEN ECONOMY
The model describes an open economy and consists of aggregate
demand and aggregate supply equations, a simple monetary policy
rule, relationships with the rest of the world (foreign output, foreign
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inflation and foreign interest rates) and also stylised factors affecting
the cost of borrowing.
Glossary
Real gaps (percentage deviations in real variables from their
long-run trends):
yt
rt
zt
yt
qt
t
ut
output gap;
real interest gap;
real exchange gap;
foreign demand gap;
real price of capital gap;
external finance premium;
foreign exchange risk spread.
Nominal variables:
it
pt
t
t4
tm
it
p
t
nominal policy rate;

log of domestic price level;
domestic quarter-on-quarter inflation (annualised);
domestic year-on-year inflation;
import inflation;
foreign nominal interest rate;
log of foreign price level;
foreign quarter-on-quarter inflation (annualised).
Structural shocks:
y
t
t 1
t 2
ts
ti
q
t
aggregate demand shock;

type-1 (persistent) cost-push shock;
type-2 (temporary) cost-push shock;
foreign exchange shock;
monetary policy surprise;
financial market shock;
external premium shock.
The superscript e denotes expectations in general; the operator Et [] denotes the model-consistent (rational) expecta-
tions; the superscript a denotes adaptive expectations. The

expectations formation is explained in Equations 9.10 and 9.11.
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Identities between log price levels and inflation rates are not
listed here.
Real trends and the foreign exchange risk spread are exoge-
nous processes, not listed here.

Equations
Aggregate demand
Demand for domestic output is affected by real monetary conditions
(ie, the real interest rate, including the external finance premium, and
the real exchange rate) and by external demand
y
yt = 1 yt1 + (1 1 )yte1 2 (rt + t ) + 3 zt + 4 yt + t
(9.3)
Phillips curve (aggregate supply)

Domestic inflation is driven by cycles in excess demand (the output
gap), two exchange rate channels (a direct exchange rate channel,
through the prices of directly consumed imports, and an indirect
exchange rate channel, through the prices of imported intermediate
inputs) and the expectations channel. Note that the Phillips curve
displays long-run neutrality, as it is easy to show that this equation
is consistent with any rate of inflation if the real gaps are closed (ie,
the real variables are on their trend paths)
1 1 2 m
(t1 ) + 2 yt + 4 zt t (9.4)
1
Furthermore, we introduce two types of cost-push shocks to domestic prices: one has more persistent effects (type 1), the other is more
temporary (type 2)
t = 1 t1 + 2 te+1
t = t 1 + (t 2 t21 )
(9.5)
Uncovered interest parity

The following equation describes the reaction of the nominal exchange rate to the interest rate differential (adjusted for a country
risk spread), and to future expectations
st = set+1 14 (it it ut ) + ts
(9.6)
Monetary policy (Taylor) rule

The central bank responds to deviations in inflation from the target (year-on-year inflation k quarters ahead) and to excess demand;
the policy rule has an autoregressive term to avoid large and rapid
swings in the policy rate settings (policy smoothing).
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Financial market conditions (real price of capital and external price

of capital)
Conceptually, we link the external finance premium to the real price
of capital: the higher the price of capital, the lower the cost of borrowing for consumers and investors (given a certain policy rate).
The price of capital is, in turn, determined by a simplified asset price
equation: as a discounted sum of future marginal products of capital
approximated by the cycle in output
q
qt = rt + yte+1 + (1 )qet+1 + t
t = qt + t
(9.7)
(9.8)
We give the following definitions for import inflation, the real

exchange rate gap and the real interest rate gap
tm = st + t
zt = st + p
t pt z
rt = it te+1 rt
(9.9)
Here the bar denotes long-term equilibrium values.

We now discuss inflation expectations (other expectations can be
thought of in the same way).
Expectations can be mixed in the model: partly forward-looking,
ie, model-consistent (based on the correct one-step-ahead predictions made by the model itself), and partly backward-looking or
adaptive:
te+1 = wEt [t+1 ] + (1 w)ta+1
(9.10)
ta+1 = ta + (t ta )
(9.11)
The authors thank Jaromir Benes for helpful comments and

discussions.
1
Iceland: although at the time of writing in 2012 the inflation target is still technically in force,
the central bank is concentrating mostly on keeping the exchange rate stable.
Meyer (2001) has a nice discussion of central bank mandates and objectives from the perspective of IT.
Although the financial crisis revived the use of other instruments, such as FX interventions or
quantity based operations, these were employed either to support the transmission of interest
rate policy or to satisfy different objectives outside the IT framework, such as pro-exporting
industrial policy.
Released by the Federal Open Market Committee on April 28, 2010.
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Such as an inflation forecast for a particular rather irrelevant sector, calculated and discussed
up to three decimal places.
In simple terms, reduced-form models explain a set of dependent variables in terms of a set
of independent variables (for example, in a regression framework). Structural models deal
with equilibrium relationships between supply and demand, which are likely to dominate in
the medium to long term.
For example, switching expenditures between cheaper and costlier goods, or deciding on
investment in productive capacity based on the cost of bank lending.
For instance, while the core projection model may work with the headline CPI and the five traditional demand components of GDP only (consumption, investment, government, exports,
imports), the now-casts and NTFs make use of a detailed sector-by-sector breakdown of the
CPI into sub-indexes, and both demand a production view of GDP flows.
Models for trend-cycle analysis are called filters because they aim at filtering out highfrequency fluctuations while identifying lower frequency relationships.
10 Non-linearities that may matter for monetary policy include an asymmetric, convex Phillips
curve (prices fall less in recessions than they rise in booms) and endogenous credibility (expectations are more difficult to anchor if the central bank has a poor track record in keeping
inflation low and stable).
11 Economic modelling software packages that offer a high degree of flexibility in incorporating
conditioning information and judgemental adjustments in simulations include the IRIS Toolbox (http://www.iris-toolbox.com), Troll (http://www.intex.com/troll) and Sirius (http://
www.ogresearch.com/products).
12 See http://www.federalreserve.gov.
13 The FRB/US model; see http://www.federalreserve.gov.
14 BEQM stands for Bank of England Quarterly Model. ToTEM stands for Terms of Trade Economic Model. KITT stands for Kiwi Inflation Targeting Technology. NEMO stands for Norwegian Economy Model. RAMSES stands for Riksbank Aggregate Macro-model for Studies
of the Economy of Sweden.
15 For instance, data on physical capital is not readily available or reliable even in many advanced
countries; the relationship between the countrys net investment position and the reported
current accounts tends to be fuzzy because of occasionally unclear definitions or hard-to-track
valuation effects.
REFERENCES
Banbura, M., D. Giannone and L. Reichlin, 2008, Large Bayesian VARs, ECB Working
Paper 966.
Benes, J., K. Clinton, R. Garcia-Saltos, M. Johnson, D. Laxton, P. Manchev and T.
Matheson, 2009, Estimating Potential Output with a Multivariate Filter, IMF Working
Paper 10/285.
Bernanke, B., J. Boivin and P. Eliasz, 2005, Measuring Monetary Policy: A FactorAugmented Vector Autoregression (FAVAR) Approach, Quarterly Journal of Economics
120(1), pp. 387422.
Bernanke, B., M. Gertler and S. Gilchrist, 1999, The Financial Accelerator in a Quantitative Business Cycle Framework, in J. B. Taylor and M. Woodford (eds), The Handbook of
Macroeconomics, Volume 1C (Elsevier).
Carabiencov, I., I. Ermolaev, C. Freedman, M. Juillard, O. Kamenik, D. Korshunov and
D. Laxton, 2008, A Small Quarterly Projection Model of the US Economy, IMF Working
Paper 08/278.
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Chari, V. V., 2010, Testimony before the Committee on Science and Technology, Subcommittee on Investigations and Oversight, US House of Representatives, June.
Chen, H., K. Clinton, M. Johnson, O. Kamenik and D. Laxton, 2009, Constructing
Forecast Confidence Bands during the Financial Crisis, IMF Working Paper 09/214.
European Central Bank, 2011, ECB Staff Macroeconomic Projections for the Euro Area,
September, URL: http://ecb.europa.eu/pub.
Faust, J., 2009, The New Macro Models: Washing Our Hands and Watching for Icebergs,
Sveriges Riksbank Economic Review, 2009(1).
Hodrick, R., and E. C. Prescott, 1997, Postwar US Business Cycles: An Empirical
Investigation, Journal of Money, Credit, and Banking 29, pp. 116.
Issing, O., 2008, In Search of Monetary Stability: The Evolution of Monetary Policy,
Contribution to Seventh BIS Annual Conference, June.
Leser, C. E. V., 1961, A Simple Method of Trend Construction, Journal of the Royal
Statistical Society, Series B 23, pp. 91107.
Meyer, L. H., 2001, Inflation Targets and Inflation Targeting, Speech at the University
of California at San Diego Economics Roundtable, July.
Norges Bank, 2011, Criteria for an Appropriate Interest Rate Path, Monetary Policy
Report 2/2011.
Solow, R., 2010, Building a Science of Economics for the Real World, Testimony before
US Congress Committee on Science and Technology, July.
Taylor, J. B., 1998, The Robustness and Efficiency of Monetary Policy Rules as Guidelines
for Interest Rate Setting by the European Central Bank, Seminar Paper 649, Institute for
International Economic Studies, Stockholm University.
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10
Term Structure of Interest Rates and

Expected Inflation
Olesya V. Grishchenko; Jing-Zhi Huang

Federal Reserve Board; Penn State University
In this chapter we report some developments in the modelling of

the term structure of interest rates and expected inflation. We first
review nominal term structure models and then we discuss models
of real term structures and expected inflation, and illustrate how
inflation expectations and risk premiums can be derived. Finally, we
discuss the implications of this research for investors and monetary
policymakers.
TERM STRUCTURE MODELLING: BASIC CONCEPTS
One of the most important aims in financial economics is to understand how expected bond returns move over time. For this purpose,
a successful modelling of both short- and long-term bond yields (ie,
the term structure) is called for. The literature on the term structure of nominal interest rates is vast, and the topic has developed
into a separate field of financial economics since the 1990s. For the
sake of brevity, we shall highlight only the key concepts and a few
of the many influential papers that have shaped the evolution of
the term structure modelling over time. Some of the mathematical
derivations are provided in the appendixes.
From the short rate to the yield curve
A crucial idea underlining most of the term structure models is the
concept of no arbitrage, ie, the assumption that there are no ways to
make a riskless profit, or, in other words, there are no self-financing
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strategies that start with zero value, have zero probability of loss
and have a positive probability of a positive profit at a later point in
time. Under the assumption that a market does not allow arbitrage
opportunities, default-free zero-coupon bond prices can be obtained
using the risk-neutral valuation approach and expressed as an expectation under the risk-neutral probability measure Q. If the market
is complete, ie, any derivative can be hedged using a self-financing
portfolio of market securities, then the above probability measure Q
not only exists but it is unique. These assumptions, together, result in
the well-defined, unique bond prices (see the appendix on page 235).
Namely, let Pt, denote the price at time t of the zero-coupon bond
maturing at time t + and let yt, be the corresponding yield. We
have

Q
Pt, = exp[yt, ] = Et
exp
t+
rs ds
The result above is quite elegant, and offers a potentially useful link
between the short rate r (which is influenced by monetary policy)
and the rest of the yield curve. However, the problem is that our
observations of the short rate r belong to the real world under the
(data-generating) probability measure (or physical measure) P. In
other words, by collecting data on the short rate (using for example
the one-month interest rate as a proxy) we might gain insight on
its dynamics under P and yet, to calculate bond prices, we have to
take expectations under Q. We need a way to relate expectations
under different (yet equivalent) measures to be able to bridge the
gap between the two worlds.
In between two worlds: the price of risk
As mentioned earlier, we need to have a model that captures the
empirical properties of the data under the physical measure P. The
no-arbitrage assumption, which ensures the existence of Q also
ensures the existence of a transformation between Q and the real
data-generating measure P (two equivalent probability measures).1
Specifically
Q
t Et [ ] = EPt [T ]
where t is the stochastic process, representing the change in probability density between the two measures. Specific functional forms
are assumed for t , both to ensure that, being a probability density transformation, it is positively defined, and in order to preserve
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TERM STRUCTURE OF INTEREST RATES AND EXPECTED INFLATION
Figure 10.1 The market price of risk

Risk-neutral
measure
Data-generating
measure
[ ]
Price of
risk
EQt []
EtP
mathematically tractability (for instance, we want to make sure that

we are dealing with Brownian motions, albeit with different drifts,
under both measures). A standard functional assumption for the discrete one-period change in measure is the exponential one, which
has the effect of only changing the drift terms (see Equation 10.4
in the appendix), leaving volatilities untouched and preserving the
analytical tractability of Brownian motions. If the market price of
risk t is zero, the two probability measures coincide. As we will see
later, the market price of risk is generally defined to be a function
of the N-dimensional state vector (subject to constraints to allow
for closed-formed solutions of affine models). Figure 10.1 illustrates
schematically the relationship between Q and P measures.
Both probability measures work
Bond prices can be calculated under either measure, after adjusting
for the appropriate change in probability density. Specifically
Q
Pt, = Et
= EPt
t+
exp
rs ds
t+

T
exp
rs ds
t
t
Both expressions lead to the same prices for zero-coupon bonds.

More explicit formulas are derived in the appendix on page 236, and
an example of the actual calculation is worked out in the appendix on
page 238. The relation between the price of risk and bonds term premiums are analysed in the appendix on page 238. A useful recursive
relation for bond prices in discrete time is presented in the appendix
on page 238.
Clearly, the choice for the dynamics of the short rate is driven by
the desire for both mathematical tractability and consistency with
the empirical behaviour of yields in the real world. In this regard,
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the most salient empirical features of the US term structure are that
the nominal yield curve is on average upward-sloping,
the standard deviation of yields decreases with bond maturity,
yields are highly autocorrelated,
term premiums change over time,
yields are not normally distributed.
A good term structure model should reproduce all or most of these

characteristics, with the Gaussian autoregressive framework being
quite common, as it leads to closed-form solutions.
Note that the term structure models described in this chapter
try to econometrically identify model parameters under the physical measure, together with the market price of risk, in a way that
is consistent with yield data. However, given that these parameters are estimated using data on yield curves over a time window,
the term structure models do not exactly reproduce all zero-coupon
bond prices.2 The econometric emphasis is driven by the desire to
understand the underlying drivers of the yield curve, and provide
guidance for bond investors and policymakers alike. Assuming you
trust the model, discrepancies between actual bond prices and model
prices might indicate trading opportunities, and you might even try
to use the model to forecast the yield curve out-of-sample.
This is different from the approach that a bond derivatives trader
would take. The latter would not greatly care about the econometric
(real world) identification of the factors driving the yield curve, but
would insist on a no-arbitrage model that can exactly reproduce the
entire (initial) yield curve at the time of valuation, so that derivatives (for example, bond options) are priced consistently with their
underlying (whether the latter is fairly priced or not). See Ho and
Lee (1986) and Heath et al (1992) for a rigorous treatment of this
approach.
The expectation hypothesis and no-arbitrage models
Before the no-arbitrage term structure models, the most common
assumption on bond yields was that they represented the expectation of short-term rates (under the data-generating probability
measure P). Specifically
yt, =
EPt
t+
t
rs ds
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Clearly, this does not hold in general except when interest rates are
certain, as
there is in general a non-zero price of risk, s 0, and
even if the price of risk were zero, so that investors are risk-
neutral (not a plausible assumption), Jensen inequality terms

(which can be substantial, especially for long-maturity yields
and in high-volatility regimes) are present

t+
EPt exp
rs ds
def
EPt
t+
t

+ Jensens terms
rs ds
Single-factor models of the short rate

Vasicek (1977) and Cox et al (1985) were the pioneers of the termstructure literature. In their models, bond yields are driven by one
stochastic variable, namely, the short rate. Assuming no arbitrage,
the short rate also determines zero-coupon bond prices, and thus
the whole term structure. In these one-factor models, yields of all
maturities are perfectly correlated (albeit not necessarily moving
one-to-one).
In Vasicek (1977), the short rate has a normal distribution and
follows the one-dimensional stochastic process
Q
drt = ( rt ) dt + dBt
Q
where Bt is a standard Brownian motion under the risk-neutral

probability measure Q. The short rate in the CoxIngersollRoss
(CIR) model has a non-central 2 distribution and follows the
process
drt = ( rt ) dt + rt dBt
Both models have closed-form solutions for zero-coupon bond

prices and yields. Note that since there is only one source of uncertainty here, we can hedge any bond with another bond of different
maturity (using the appropriate hedge ratio). In other words, we
can build a risk-free portfolio using only two zero-coupon bonds of
different maturities.
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Figure 10.2 Multi-factor term structure models

Stochastic
state variables
Instantaneous
short rate
Xt = (X1,t ,,XN,t)
rt = R(Xt ,t)
Multi-factor models of the short rate

Given that the assumption of perfect correlations among bond yields
is clearly violated in practice, researchers have developed multifactor models where the starting point is the specification of the
dynamics of a vector of stochastic state variables (which, as the
name implies, characterise the state of a dynamic system). Let
Xt = (X1,t , . . . , XN,t ) denote the time-t value of an N-dimensional
vector Xt . One commonly used specification under the risk-neutral
measure Q is as follows
Q
dXt = Q (Xt , t) dt + Q (Xt , t) dBt

Q
where Bt is an N-dimensional Brownian motion vector under Q

(ie, a Markov diffusion). Specific choices of the N-dimensional vector Q (Xt , t) and the N N matrix Q (Xt , t) will determine the
behaviour of the short rate, and consequently the price of the zerocoupon bonds, Pt, , and the yield yt, . Furthermore, the instantaneous short rate rt is assumed to be a function of the vector of state
variables and time, ie, rt = R(Xt , t), as shown in Figure 10.2. Note
that in an N-factor model we can build a risk-free portfolio using
N + 1 zero-coupon bonds of different maturities.
Examples of multi-factor models include the class of affine term
structure models (see page 215), which include the multi-factor
Vasicek and CIR models as special cases.
As mentioned before, the Q-dynamics of state variables can be
translated into their counterpart under the P-measure by applying
the exponential change of measure reviewed in the appendix on
page 236. Namely, the following transformation
Q
dBPt + t dt = dBt
where t is an N-dimensional vector of the market prices of risk for

each state variable in the system leading to the specification of X
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under P
Q
dXt = Q (Xt , t) dt + Q (Xt , t) dBt

= (Xt , t) dt + (Xt , t) dBPt
Here BP is a P-Brownian motion and the drift and diffusion terms

are given by
(Xt , t) = Q (Xt , t) + Q (Xt , t)t
(Xt , t) = Q (Xt , t)
Therefore, the change of measure affects only the drift vector,

although under P the dynamics of the state vector is not necessarily affine anymore. Specifically, an affine diffusion under the riskneutral measure Q will be affine under the data-generation measure
P only if the vector Q (Xt , t) t is itself affine.
How many factors are necessary?
Clearly, as a first step, the number of state variables, or factors, that
span the time variation of bond yields needs to be determined. In an
influential study, Litterman and Scheinkman (1991) show that three
latent factors can explain most of the variation in the term structure
of nominal interest rates (ie, about 97% of their variance), and call
these three factors level, slope and curvature, respectively.3
As a result, most of the empirical and theoretical literature since then
has considered three-factor term structure models of interest rates
(ie, N = 3 in Figure 10.2). Note that, even with only three factors,
there are a large number of parameters to be estimated. This implies
that over-fitting might become an issue even for the parsimoniously
specified term structure models.
Affine term structure models
Although many choices can be made, one important class of models
arises when
the drift Q (Xt , t),
the variance matrix (Xt , t)T (Xt , t) and
the short rate rt
are all assumed to be affine functions of the state variables (the superscript T indicates transposition). In such models, bond yields also
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turn out to be affine, and zero-coupon bond prices are exponentially

affine. Namely, we have
yt, = a + bT Xt
Pt, = exp[yt, ] = exp(A + BT Xt )
where a = A / is a scalar, and b = B / is an N 1 vector (as
before, the superscript T indicates transposition). Affine dynamic
term structure models (DTSMs) allow for closed-form solutions of
bond prices as shown by Duffie and Kan (1996). This, in turn, makes
it possible to explore the models ability to fit the time variation
of bond yields and forecast expected bond excess returns (see the
appendix on page 239 for details on the n-period expected returns).
Constant volatility affine AR(1) model
A simple affine specification, albeit not the most general one, is
obtained by assuming a constant volatility matrix and modelling
the state vector as an autoregressive AR(1) process, with both the
short rate and the price of risk depending linearly on the state
variables. In discrete time, this specification can be written as follows
Xt = + Xt1 + BPt
rt = 0 + TX Xt
t = 0 + X Xt
In this case, the state vector dynamics is clearly affine under both Q
and P measures. See the appendix on page 240 for explicit solutions
for yields and bond price in this model.
However, note that for an N-dimensional state vector, the equations above introduce a large number of parameters to be estimated
(Table 10.1). This poses a common empirical challenge for all multifactor term structure models. For example, for the case of N = 3,
there are a total of 37 parameters to be determined.
Explicit solutions for yields and bond price for this simple model
are derived in the appendix on page 240.
Stochastic volatility models
The volatility matrix driving the evolution of the state vector does
not need to be constant as in the simple AR(1) model introduced
above, and can, in general, be a function of time and the state vector
itself. However, in affine term structure models, the variance needs
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Table 10.1 Parameters in the affine constant volatility, AR(1) N -factor

model
0
X
0
X
N
N2
N2
1
N
N
N2
Total
3N 2 + 3N + 1
to be an affine function, so that the volatility matrix has the following

form (Dai and Singleton 2000)
(Xt , t) = 0 ,
s(Xt ) = 0 s0 + sTx Xt
where 0 is an N N matrix, and s(Xt ) is a diagonal N N matrix,

ie

s
+ sT1x Xt 0
0
10
..
.
0
0
0
s(Xt ) =
..
..
.
.
0
0
sN0 + sTNx Xt
where s10 , . . . , sN0 are scalars and sT1x , . . . , sTNx are 1 N row vectors.
As mentioned earlier, to ensure that the dynamics is affine under
both Q and P measures, and that bond yields are affine, the product
(Xt , t) t should be affine (see also the appendix on page 240 on
this point). This implies that in stochastic volatility term structure
models, the market price of risk is not affine. The most common
functional assumption for the market price of risk, albeit not the
most general one (Dai and Singleton 2000), is
t = s(Xt )0
where 0 is an N 1 column vector.

Dai and Singleton (2000) classify term structure models by exploring the trade-off between a relative goodness of fit and flexibility of
the affine dynamic term structure models.4 They conclude that a
three-factor model (N = 3), with conditional volatility driven by
one factor, provides the best fit to historic movements of short- and
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long-term yields. As a comparison, three-factor models with two

state variables driving conditional volatilities require more restrictions on correlations among factors in order to obtain well-defined
bond prices, a property that Dai and Singleton call admissibility.
They also show that three-factor models with all three factors
affecting conditional volatilities theoretically require that the conditional correlations be zero and that the unconditional correlations be non-negative. This property is inconsistent with historical data of US interest rates, which points to empirically negative
correlations. Consequently, three-factor models with all three factors driving conditional volatilities are not used in term structure
modelling.
Duffee (2002) argues that completely affine models (ie, models where zero-coupon bond yields under physical and risk-neutral
measures are affine functions of the state vector) fail in forecasting future bond yields. He proposes a generalised version of these
models, called essentially affine DTSMs. These models retain all
the affine time-series and cross-sectional properties of bond prices,
yet they allow for a greater flexibility in fitting time-varying market prices of risk. The essentially affine models nest the class of
completely affine models by specifying the market price of risk as
t = s(Xt )0 + s (Xt )1 Xt
where
s(Xt )ii = (s0 + sT Xt )1/2

x
s
ii (Xt ) =
0
if inf (s0 + sTx Xt ) > 0

otherwise
and 1 is an N N matrix. While this formulation preserves the

same physical dynamics as completely affine models do, there are
some important differences. First, Tt t is no longer affine in Xt . Second, the essentially affine set-up allows for an independent variation
(from bond yields) in prices of risk. Third, the sign restriction on the
individual elements of the market price of risk t no longer exists.
These features help to make more accurate yield forecasts, albeit at
a cost of fitting interest rate volatility.
Dai and Singleton (2002) also generalise market prices of risk
within the class of affine DTSMs in order to match key empirical
findings of Fama and Bliss (1987) and Campbell and Shiller (1991).
Dai et al (2010) consider a class of discrete-time, nonlinear dynamic
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term structure models, in which the distribution of the state vector

is affine under Q, while the market price of risk is nonlinear in Xt ,
leading to a nonlinear dynamics of the bond yields under the physical measure P. Ahn et al (2002) and Leippold and Wu (2002) specify
a class of term structure models where the short rate is a quadratic
function of the underlying state vector.
Latent factors and macroeconomic variables
An important question facing financial economists is identification
of the latent factors and/or macroeconomic variables that can potentially explain the behaviour of the yield curve. This has motivated
a new and yet fast growing literature on so-called macro-finance
models that include observable macroeconomic variables into the
term structure models of nominal interest rates5 (see, for example,
Kim (2009) and Duffee (forthcoming) for surveys of this literature).
In a pioneer study of macro-finance models, Ang and Piazzesi
(2003) propose a five-factor no-arbitrage term structure model of the
nominal yield curve, where two macroeconomic variables are identified with real growth and inflation, and the remaining three factors
are latent and orthogonal to the two directly observable macro variables; namely, the macro dynamics do not depend on interest rates,
an assumption made for mathematical tractability.6 All five factors
are modelled in a Gaussian autoregressive framework, and the short
rate is assumed to be affine in the state vector and driven by growth
and inflation (similarly to the Taylor rule) plus three latent factors.
The market price of risk is also assumed to be an affine function of
the five factors. In this set-up, yields are affine in state variables, term
premiums vary over time and yield data can be used to extract the
latent factors.
Ang and Piazzesi (2003) construct the two macroeconomic factors taken to be the principal components of two baskets of economic variables, one representing price levels (including consumer,
producer and commodities prices) and the other representing the
measures of real output (including employment and industrial production and two other variables). The coefficients for the inflation
and growth factors are estimated in a regression framework under
the data-generating probability measure. Both coefficients are found
to be positive (ie, higher inflation and higher growth increase the
short-term rate), although the growth coefficient is dependent on the
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time window used for estimation. Bond data used to estimate the
five-factor term structure model are monthly nominal zero-coupon
yields (continuously compounded) over the period 19522000. By
using the variance decomposition, Ang and Piazzesi show that the
two macro factors are major drivers of yields, especially in the short
end of the yield curve, while the latent factors tend to dominate in
the long end of the curve.
To summarise, in addition to the aforementioned studies, the
1990s and early 2000s produced a wealth of research regarding the
information contained in the term structure of nominal interest rates.
The interested reader can refer to a thorough treatment of DTSMs
and their estimation by Singleton (2006) and a comprehensive review
by Piazzesi (2010) for a more complete reference.
THE US TIPS MARKET
To a large extent, interest in the modelling of real interest rates has
been fostered by the development of the market for US Treasury
Inflation-Protected Securities (TIPS), launched in 1997. Since then,
government bond markets, the market for US Treasury nominal debt
and the market for inflation-indexed debt have provided an excellent laboratory for studying macroeconomic issues such as inferring inflation expectations, estimating inflation risk premiums and
extracting the probability of deflation. See Campbell et al (2009) for a
detailed and comprehensive overview of inflation-indexed markets
in both the US and the UK.
Initially the TIPS market did not attract the attention of many
researchers, partly due to its liquidity problems, and partly because
inflation (or disinflation) concerns were not as common in late 1990s
as they are at the time of writing. However, in the late 200s this
changed, in part because rising global risks contributed to a flightto-quality from riskier equities markets to safer markets such as
the markets for US Treasury nominal and inflation-indexed debt.
For instance, according to Morningstar (2010), total net asset values
of TIPS funds increased by more than 54% (or about US$19.5 billion)
over the one-year period from January 2009 to January 2010.
The most important feature of TIPS is that their principal and, consequently, the coupon payments are linked to the value of the Consumer Price Index (CPI). As such, these payments are denominated
in real rather than nominal terms, and thus TIPS can be considered
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to be almost free of inflation risk. The qualifier almost is related

to the fact that TIPS prices are linked to the inflation index, but with
an interpolated lag of between two and three months.7 The difference between nominal Treasury and TIPS yields of equivalent maturities represents a compensation required by investors for bearing
inflation risk, and is sometimes referred to as a break-even inflation rate. This compensation includes both expected inflation and
an inflation risk premium due to inflation uncertainty and, in addition, a potential liquidity premium. See Bekaert and Wang (2010) for
a comprehensive survey focusing on the inflation risk premium.
Given that the TIPS market has grown significantly and its liquidity has improved, researchers have naturally become interested in
modelling the term structure of real interest rates, ie, the term structure of the TIPS yields that can be interpreted as real interest rates.
This issue is of considerable interest to both bond investors and policymakers because the joint dynamics of nominal and real interest
rates also determine the dynamics of inflation expectations and inflation risk premiums.8 First, more accurate forecasts of real rates can
provide more accurate information about future economy growth.
Second, joint modelling of the term structures of nominal and real
rates provides a wealth of information about inflation compensation
and its two components, the expected inflation and the inflation
risk premium. While the literature on the term structure of nominal yields is quite mature, financial economists started developing
models on real interest rates only in the early 2000s.
Parts (a) and (b) of Figure 10.3 show the 10-year zero-coupon US
nominal yield and the TIPS real yield from 2000 onwards; part (c)
shows the break-even inflation rate. Note that the 10-year yields
are used in the figure because they are believed to reflect long-term
expectations about inflation and economy growth. The time series in
Figure 10.3 are based on the fitted yield curve procedure of Svensson
(1994), which is an extension of Nelson and Siegel (1987). Gurkaynak
et al (2010) describe Svenssons fitting procedure applied to TIPS
data.
MODELLING BOTH REAL AND NOMINAL TERM STRUCTURES
The goal of developing the real term structure models is somewhat different from the one behind nominal term structure models.
Here, researchers are interested not only in fitting the yield curve
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Figure 10.3 Ten zero-coupon nominal and TIPS yields and inflation
break-even rates
8
6
%
4
(a)
2
2000
2002
2004
2006
2008
2010
2012
2002
2004
2006
2008
2010
2012
2002
2004
2006
2008
2010
2012
6
4
%
2
(b)
0
2000
3
2
%
1
(c)
0
2000
(a) Ten-year nominal yields; (b) ten-year TIPS yields; (c) ten-year inflation compensation.
Source: Grishchenko and Huang (2010).
and forecasting excess bond returns, but also in assessing inflation

expectations and inflation risk premiums.
We can write two separate equations (derived in the appendix
on page 245), one for real and one for nominal yields, in order to
identify the different risk premiums affecting one and/or the other.
Neglecting Jensens terms, we have
Yt,R =
and
Yt,N =
EPt (It,R ) +
EPt (It,R ) + Tt,R

1
EPt [It, ] + Tt,R + IRPt,
where Tt,R denotes the real interest rate risk premium and IRPt, is
the inflation risk premium.
As mentioned earlier, the break-even inflation rate, BEIt, , ie, the
difference between nominal and TIPS yields, represents the amount
of inflation compensation that investors in the nominal Treasury
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debt require (ignoring liquidity) and is frequently referenced by

policymakers and market participants alike. Inflation compensation itself consists of expected inflation EPt [It,inf
]/ and an inflation
risk premium IRPt,x (see the appendixes on pages 242248 for the
mathematical details)
yt,N yt,R = BEIt, =
EPt [It,inf
] + IRPt,
Obviously, the inflation risk premium depends on the correlation

between the real rates and inflation.9 The equation above shows
how movements in nominal rates are the result of changes in real
rates and the inflation break-even rate.
As Figure 10.2(c) shows, inflation compensation (the difference
between nominal and real yield) has been quite variable in the 10year period 200111. An interesting question is the extent to which
this time variation is due to changes in inflation expectations versus
those in the inflation risk premium.
Note that we need to be careful about defining real yields. These
are not necessary equal to TIPS yields because of
(i) liquidity problems associated with TIPS, such as before 2004
and during the financial crisis in autumn 2008,
(ii) inflation indexation lag in the TIPS and
(iii) the embedded deflation floor.
These issues, and possible solutions, are discussed later.
As for nominal models, real term structure models also impose
specific restrictions on the factor dynamics in the risk-neutral world,
in order to be consistent with empirical data in the real world.
For example, Fama (1990) documents that the one-year expected
inflation rate and the expected real return on one-year bonds move
in opposite directions and are related to business-cycle conditions
(using the yield spread on a five-year bond over the one-year spot
rate as a proxy). Yield spread is countercyclical: it is high (low)
around business troughs (peaks). Fama finds that the yield spread is
positively related to changes in inflation and negatively to changes
in real returns. In particular, the yield spread forecasts a drop in
inflation and increase in real returns after business cycle peaks.
Thus, a successful term structure model should generate a negative
correlation between expected inflation and real rates.
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A BRIEF REVIEW OF THE LITERATURE

The literature on real term structure models starts with the work
of Barr and Campbell (1997), who model expected log inflation and
real interest rates as trend-stationary autoregressive AR(1) processes
(ie, a time-series approach). Using UK inflation-indexed data, they
find that changes in real rates and expected inflation are negatively
correlated at long, but not short, horizons.
Ang et al (2008) use a three-factor (two latent ones and one observable) regime-switching model in order to derive both nominal and
real yields, and isolate each of the two components of inflation compensation: inflation expectations and inflation risk premium. They
use a time-varying but regime-independent market price of risk
(latent) factor, a (latent) regime-switching factor and an observable
inflation factor. In the empirical analysis, nominal yields (one-year,
three-year and five-year maturities) and US CPI data are used for
calibration, while real yields are derived within the model. The threefactor model can generate a negative correlation between real rates
and inflation (both unexpected and expected) at short maturities,
albeit the correlation turns positive at long maturities. Furthermore,
Ang et al show that real rates are mostly flat across maturities, ie,
there is no real rate term premium, and that the positive nominal
yield term premium is due to inflation compensation (a flat expected
inflation term plus an upward-sloping risk premium). Results from
variance decomposition show that only 20% of changes in nominal
yields is due to changes in real rates, while the remaining 80% is
caused by changes in inflation compensation. Expected inflation is
found to be the main driver even at short maturities (80% at the oneyear horizon; 70% at the five-year horizon), while the inflation risk
premium contributes 0% of variance at one-year maturity and 10%
of variance at the five-year maturity. In other words, the positive
nominal term premium is mostly due to an upward-sloping inflation risk premium, but most of the dynamics of the nominal curve
are explained by changes in inflation expectations.
An interesting approach is pursued in Chernov and Mueller
(forthcoming), who model the term-structure and inflation expectations using a five-factor model, with two macro variables (the US
real GDP and CPI) and three latent factors. The first two latent factors
are easily identified as the factors driving the level and slope of
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nominal rates. The third latent factor is interpreted as a level factor for survey inflation expectations (survey-based inflation expectations are formed in the real-world probability). While inflation
affects the nominal curve, this latent survey factor does not (it is
hidden), and it represents information about the expected path of
inflation, which is not captured by inflation itself. In addition to quarterly GDP and CPI data, both nominal and real (ie, US TIPS) yields
are used in the calibration, as well as inflation expectations from
three popular market surveys (the Livingston Survey, the Survey
of Professional Forecasters and the Blue Chip Economic Indicators
Survey)10 . The survey factor and survey inflation data are found
to greatly increase out-of-sample forecasting of future inflation. The
study also points out the following two consequences of using US
TIPS data (from 2003 onwards):
1. the average level of real yields is higher (implying a lower
average inflation risk premium);
2. real rates are more volatile (implying a decline in the volatility
of the inflation risk premium).
The above findings might partly be caused by liquidity problems
on the TIPS market. For example, higher real yields might include
a liquidity premium that would result in the downward bias of
the average inflation risk premium. Therefore, liquidity should be
accounted for when TIPS yields are modelled. DAmico et al (2009)
were among the first to take into account TIPS liquidity in a model of
both nominal yields and TIPS yields. They found that, while three
principal components explain over 97% of weekly nominal yield
changes, a fourth factor is needed to explain the changes of both
nominal yields and TIPS yields. The latter factor can be interpreted
as a liquidity premium in TIPS yields, while the remaining three are
the usual level, slope and curvature (latent) factors driving both yield
curves. Thus, they use a four-factor Gaussian term structure, where
nominal and US TIPS yields are modelled jointly in order to estimate
the TIPS liquidity premium, expected inflation and inflation risk premium. DAmico et al show that ignoring the liquidity component can
lead to severely biased estimates of expected inflation and inflation
risk premiums. Specifically, if TIPS yields are identified with real
rates, model-implied inflation expectations do not fit the empirical
downwards trend observed in inflation survey data over time, and
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the estimates of the inflation risk premium are low or even negative.
When the liquidity factor is introduced, the DAmico et al model
is able to reproduce the downwards trend in expected inflation, as
well as positive inflation risk premium. Consequently, a change in
TIPS break-even rates cannot simply be interpreted as a change in
inflation expectations, as both the inflation and the liquidity risk
premiums play important roles.
Adrian and Wu (2010) used a five-factor model with two inflation
factors, two real factors and a factor that governs the dynamics of
variances and co-variances of state variables. They found that inflation expectations differ significantly from the break-even inflation
rate when inflation volatility is high. Chen et al (2010) estimated a
two-factor term structure model with real rates and expected inflation as state variables, and found that the expected inflation is flat,
while the inflation risk premium is upward sloping (in line with Ang
et al (2008)).
Haubrich et al (2011) estimated a seven-factor term structure
model, using nominal Treasury yields, inflation survey forecasts
(from the Blue Chip Economic Indicators Survey and the Survey of
Professional Forecasters), realised inflation rates and zero-coupon
inflation swaps rates. Their data span the period from January 1982
to May 2010 (although the inflation swap data only starts in April
2003). Inflation swaps are the most liquid inflation derivative contracts and are quoted for maturities ranging from one year to 30 years
(see Chapters 7 and 8 herein). They assume that nominal and real
yields are driven by three state variables that represent the shortterm real interest rate, expected inflation and long-run inflation
(what they call inflations central tendency), in addition to four
volatility (price of risk) factors, which are a mix of normal and chisquared innovations, follow Garch processes and determine bond
risk premiums. Haubrich et al found that the short real interest rate
is the most volatile component of the yield curve and displays significant mean reversion. Expected inflation over short horizons was
also found to be volatile, negatively correlated to the real rate and
mean reverting. Long-term inflation expectations declined substantially over the 19822010 sample period, consistent with the Federal
Reserves credibility in maintaining price stability. The study also
found evidence of a real interest rate term premium Tt,R , which was
substantial, averaging 102 basis points (bp) and varying between
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87 and 121bp for the 10-year zero-coupon bonds over the sample
period. The 10-year inflation risk premium has an upward-sloping
term structure, with the average of 42bp and varying between 23
and 55bp over the sample period. Incidentally, the real interest rates
risk premium was also found to be predominant in the eurozone
area (Hrdahl and Tristani 2007), although an inflation premium
was also present.
According to Haubrich et al, one advantage of their approach is
that the inflation expectations and real yields obtained from their
model are more accurate, because inflation swap rates are less
affected by liquidity problems in the TIPS market. However, some
market participants point out that the inflation swaps market is considerably more illiquid than the TIPS market, and inflation-swap
implied break-evens are consistently higher than TIPS-based breakevens by about 20bp.11 Therefore, it may be interesting to see if the
difference between inflation swap rates and TIPS inflation breakeven rates tends to be correlated with liquidity measures such as
the bidask spread in the TIPS market. Note that, during the market
dislocation in autumn 2008, bidask spreads widened considerably
in the TIPS market, but this effect was much more muted in the
inflation swap market.
Buraschi and Jiltsov (2005) provide a structural approach to estimating inflation expectations. They developed a real business cycle
model with a monetary channel to study the nature of deviations
from the expectations hypothesis and estimated a term structure of
the inflation risk premium. In their model, the inflation risk premium
was upward sloping, with the estimates between 20 and 140bp and
an average of 70bp at the 10-year maturity over the sample period
19612000.
An alternative model-free approach can be found in Grishchenko and Huang (2010), which, in the spirit of Evans (1998), is
arbitrage-free and also easy to implement. Specifically, this approach
takes the nominal and TIPS yields as given, and does not involve
any term structure model. Furthermore, various measures of inflation forecasts are used to identify expected inflation, and the inflation
risk premium can be estimated without using a term structure model
either. Grishchenko and Huang derived real yields by including
two explicit adjustments to TIPS yields, a three-month TIPS indexation lag correction and a liquidity premium. Taking these two into
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Barr and Campbell (1997)
Model specification
Buraschi and Jiltsov (2005)
Two factors, expected inflation and real rate are

trend-stationary AR(1) processes
Two factors: expected inflation and log real rate
are AR(1) processes
Five factors: inflation and economic growth and
three latent factors
Structural monetary real business cycle model
Ang et al (2008)
Chernov and Mueller (2008)
Three factors: inflation rate, two latent factors

Three factors: inflation, output, short interest rate
Adrian and Wu (2010)
Five factors: inflation, real rates,

variancecovariance factor
Four factors: three latent factors and
one liquidity factor
Model-free approach
Campbell and Viceira (2001)

Ang and Piazzesi (2003)
DAmico et al (2009)
Grishchenko and Huang (2010)
Chen et al (2010)
Haubrich et al (2011)
Grishchenko et al (2011)
Two factors: real rate and expected inflation

Seven factors: real rate, two inflation factors and
four volatility factors
Two factors: nominal rate and inflation
Data used
UK inflation-indexed bonds
N/A
US Treasury bonds, CPI,
real activity measures
US Treasury bonds,
CPI, M2
US Treasury bonds, CPI
US Treasury bonds,
CPI, GDP
US Treasury bonds,
TIPS, CPI
US Treasury bonds,
TIPS, CPI, surveys
US Treasury bonds, TIPS,
CPI, surveys
US Treasury bonds, TIPS, CPI
US Treasury bonds, TIPS,
surveys, inflation swap rates
US Treasury bonds, TIPS, CPI
perrucci 2012/7/11 17:12 page 228 #250
Reference
228
Table 10.2 Real and nominal term structure models
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account, they found that the inflation risk premium overall does not
exceed 10bp. This estimate is much lower than those obtained earlier via various structural model estimations. Table 10.2 provides a
summary of the models in this literature.
ZERO-COUPON TIPS YIELDS VERSUS REAL YIELDS
Liquidity effect in TIPS
Simple TIPS yields are biased estimates of real yields, as they are
known to contain a sizeable liquidity premium, at least in the early
years of the development of the TIPS market. Therefore, we need
to make an appropriate correction when working with TIPS yields.
Clearly, illiquidity drives TIPS prices down and TIPS yields up. If
we abstract for a moment from the issue of the indexation lag, the
R
difference between TIPS yields yt,TIPS
and real yields yt, is attributed
to a liquidity premium Lt,
R
yt,TIPS
= yt, + Lt,
This implies the following relation among nominal yields yt,N ,

TIPS yields, the liquidity premium, inflation expectations and the
inflation risk premium
yt,N = yt,TIPS
Lt, +
EPt [It,inf
] + IRPt,
The above equation shows that the inflation risk premium might be
understated if the liquidity adjustment Lt, is ignored. We can use
several methods to estimate the liquidity premium. For example,
Lt, can be calculated as the difference between real yields (derived
within a term structure model) and actual TIPS yields. Alternatively,
we can use other estimation techniques that are less dependent on
model specification, such as simply comparing TIPS prices with a
benchmark fitted curve, or regressing TIPS break-evens on several
proxies for market liquidity.
As mentioned earlier, DAmico et al (2009) used a four-factor affine
term structure model to fit both nominal and real term structures.
In their model, the instantaneous real rate, the instantaneous nominal rate, the price of nominal rates risk and the price of real rates
risk are affine functions of three latent factors Xt = (X1t , X2t , X3t ).
In addition, the liquidity premium (and an instantaneous liquidity
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spread) is explicitly modelled as the sum of a deterministic maturityindependent downwards trend Ld , and an (affine) stochastic component Lst, that depends on the three latent factors mentioned above
(ie, on the status of the economy) plus a fourth (TIPS-specific) factor
t orthogonal to the others
X
Lt, = Ld + Lst,
t
Lst, = a + bT Xt + c X
where bT is a 1 3 row vector and c is a scalar. The TIPS liquidity premium represents the difference between TIPS yields and real
yields and has both a deterministic component (which decreases the
premium over time to account for the increased liquidity in the US
TIPS market) and a stochastic component (in general, correlated with
the three latent factors driving both real and nominal yield curves).
DAmico et al found that the deterministic liquidity component premium was high in the early 2000s (as high as 120bp in 1999), but
came down significantly to about 10bp in 20045. After removing
this deterministic trend, DAmico et al found that stochastic component of the liquidity risk premium has been stationary since then
and had varied between 50 and 50bp. The term structure of the liquidity premium in their model is, generally, flat. DAmico et al also
found that the variation in the 10-year liquidity premium drives
over 20% (but with large standard errors) of the variation in inflation break-even rates, while the rest is due to variation in inflation
expectations (55%) and inflation risk premium (about 25%). As for
yields, US TIPS yield variance is dominated by changes in real yields
(119% at the 10-year horizon, with the rest 19% due to the liquidity
premium), while changes in the 10-year nominal yields are due to
changes in real yields (67%), changes in inflation expectations (23%)
and variation in inflation risk premium (10%), in contrast with, for
example, Ang et al (2008).
Pflueger and Viceira (2011) derive a higher estimate, about 70bp,
for the liquidity premium in normal years (outside early TIPS years,
when the liquidity spread was in excess of 100bp, and the 20089
financial crisis, when it reached over 200bp). They regress the TIPS
inflation break-evens on four proxies for market liquidity, ie, the offthe-run 10-year nominal spread, the GNMA spread to the on-the-run
nominal treasury, the difference in trading volumes between TIPS
and nominal treasuries, and the difference in 10-year asset-swap
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spreads between TIPS and nominal treasuries

BEIt, = a0 + b1 X1t + b2 X2t + b3 X3t + b4 X4t + t
Clearly, variables that indicate worsening (improving) liquidity
should lower (increase) the TIPS break-even rate and enter with a
negative (positive) slope coefficient. As the independent variables
are normalised to be zero in conditions of perfect liquidity, the liquidity premium is taken as the maturity independent estimate from
the regression above, specifically
Lt = (b 1 X1t + b 2 X2t + b 3 X3t + b 4 X4t )
Grishchenko and Huang (2010) computed a liquidity risk premium
using a regression approach similar to that in Pflueger and Viceira
(2011), but controlling for structural changes in liquidity conditions
through the 2000s. They found that, while the former is relatively
small in magnitude, the TIPS liquidity premium was substantial in
the early 2000s (albeit lower than the levels obtained by DAmico et
al (2009) and Pflueger and Viceira (2011)), thereby driving the wedge
between TIPS yields and real yields.
To conclude, despite different estimates of the magnitude of the
liquidity premium, it is clear that a bias exists, and the liquidity effect
should be taken into account when estimating inflation expectations
and inflation risk premiums.
Indexation lag in TIPS
Fully indexed bonds are different from the TIPS, as the latter includes
a three-month indexation lag in the CPI level for computing nominal cashflows throughout the bonds life and also a deflation protection upon maturity. The indexation lag is an interpolation between
a three-month lag and a two-month lag because the price level is a
continuous process, but we measure inflation monthly. Thus, some
researchers view the indexation lag as a 2.5-month lag, while others assume that investors observe TIPS prices and yields on the last
business day of the month (for settlement on the first day of the following month), so that the interpolation lag in the daily price index
is exactly three months. For simplicity of exposition, we consider
the case with the exact three-month indexation lag correction. This
does not materially affect our exposition. The indexation lag correction between real and TIPS yields is derived in the appendix on
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pages 243244 and is given by

yt,R3M = yt,TIPS
lagt,
Deflation floor in TIPS
The deflation floor, or deflation protection, in TIPS refers to the fact
that the principal payment of the TIPS cannot fall below the stated
principal value in the contract. Thus, if the cumulative inflation is
negative over the bonds life, the principal payment is not revised
downwards. The same is not true for TIPS coupon payments, which
can be revised upwards or downwards based on the cumulative
inflation applied at the time of the calculation. Typically, the value
of the deflation floor is neglected when computing the model-based
TIPS prices and yields. This introduces a negative bias to real yields
calculated without including the floor, although it could be argued
that, at least historically (for example, in autumn 2008), the liquidity
effect, which acts in the opposite direction, has dominated.
Grishchenko et al (2011) use a two-factor affine Gaussian model of
the nominal short rate (using the three-month Treasury bill rate as a
proxy) and inflation (using the non-seasonally adjusted CPI, which
is the same index TIPS are linked to) to derive closed-form solutions
for the values of both TIPS (including the deflation floor) and nominal bonds. Using the data from January 1997 to May 2010, they found
that the embedded deflation option was economically and statistically significant. Ten-year estimated deflation floor values vary from
zero to US$0.0615 per US$100 face value, while five-year estimates
are substantially larger, with a maximum of US$1.45 per US$100 face
value. Thus, shorter-term values of deflation floors implied by TIPS
prices are higher than longer-term ones. This result is not surprising,
given that the TIPS indexation is linked to a cumulative inflation over
the life of the bond. Therefore, it is more likely that a shorter-term
option will end up in-the-money than a longer-term option will. The
reason is that historically cumulative inflation has been larger over
the longer horizons than over the shorter ones, due to the positive
inflation in most of the periods with a few exceptions. For example,
the CPI actually fell during two consecutive months in autumn 2008.
Finally, Grishchenko et al showed that the time variation in the value
of deflation floor option is useful for predicting future inflation, even
when more traditional variables are included.
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IDENTIFICATION ISSUES: INFLATION EXPECTATION VERSUS

RISK PREMIUM
As mentioned above, identification issues arise because inflation
compensation includes both the expected inflation, It, , and the
inflation risk premium, IRPt, , as follows
yt,N yt,R =
EPt [It,inf
] + IRPt,
Within the affine framework, It,inf

is also an affine function of state
variables. In such a set-up, once the model parameters are estimated,
expected inflation is calculated within the model, while the inflation
risk premium is computed as the difference between inflation compensation, yt,N yt,R , and expected inflation, EPt [It,inf
]. Although this
approach is perfectly consistent when working with the affine DTSM
models, its implementation requires assumptions about the number of factors, their identification (observable versus latent), and the
underlying factor dynamics (eg, Gaussian versus square root versus
regime-switching models).
IMPLICATIONS FOR INVESTORS AND POLICYMAKERS
Benefitting from an increasing set of empirical data thanks to the
rapid growth in the US TIPS and other inflation-linked markets, the
research on real term structure models has important implications
for both bond market investors and policymakers alike. Bond market
participants are interested in the forecasting aspect of these models
for trading purposes, while monetary policymakers use these models to understand the links between the short and long ends of the
curve, and to gauge inflation expectations.
In addition, term structure models are valuable tools for the US
Treasury to determine the best funding options, such as choices on
debt maturity and the issuance of nominal versus inflation-linked
bonds. TIPS can potentially provide significant savings in funding
costs for the US Treasury because it can issue inflation-indexed debt
at lower inflation-adjusted yields than otherwise comparable nominal Treasury debt (although initially the TIPS programme was associated with significant liquidity-related costs to the Treasury; see
Roush 2008). The reason is that the inflation risk premium does not
have to be paid to real bond investors, as opposed to investors
in the nominal US Treasury debt market. Dudley et al (2009) estimated the 10-year inflation risk premium to be around 40bp, and
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concluded that the Treasury could have saved as much as US$22 to

US$32 billion if the TIPS market had been as liquid as the market for
off-the-run nominal Treasury debt.
TIPS are also an important market pricing mechanism, a barometer of the market inflation expectations and real rates, and thus
are quite useful to policymakers. Given that overall price stability
is one of the objectives of the Federal Reserve, TIPS can be used to
help gauge whether long-term inflation expectations remain well
anchored, especially in the face of (short-term) inflation shocks. Furthermore, TIPS provide incentives for responsible fiscal policy. The
recognition by the general public and the market that the government will have to make higher nominal payments on TIPS if inflation rises contributes to fiscal credibility and well-behaved inflation
expectations. As an added benefit, the Treasury Department can better match revenues and expenditures, because TIPS are linked to
inflation (as are tax receipts).
Finally, TIPS may give the Treasury access to a broader investor
base, which may reduce the overall funding costs (Bitsberger 2003).
Indeed, it seems that TIPS have been successful in providing diversification benefits to investors. Several studies, including Campbell
and Viceira (2001), Campbell et al (2003, 2009), Kothari and Shanken
(2004), Roll (2004), Dudley et al (2009), Barnes et al (2010), Bekaert
and Wang (2010) and Huang and Zhong (2011) have supported this
claim. Campbell et al (2009) and Huang and Zhong (2011) provide
further evidence on the negative correlations between TIPS and
stock returns. For instance, Campbell et al show that TIPS and the
Center for Research in Security Prices (CRSP) Stock Value-Weighted
Index are predominantly negatively correlated over the period 1999
2009. Huang and Zhong document that the dynamic conditional correlation as defined in Engle (2002) between TIPS and the S&P 500
index was mostly negative during the period 19992010, and that the
unconditional correlation between the two asset classes was 0.18
over the same period.
Studies of real term structure models also play an important role
in the development of the inflation-linked derivatives market. For
instance, consider the fast growing inflation swaps market. These
contracts are used by dealers to hedge their cash TIPS position, and
by other market participants to receive or pay inflation over a specific
term. Inflation swaps can also be used as an alternative measure of
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inflation expectations (Haubrich et al 2011). In addition, investors

can implement an arbitrage strategy using inflation swaps, as shown
in Fleckenstein et al (2010). For other inflation-indexed derivatives,
such as swaptions, caps and floors, see, for example, Ho et al (2011).
CONCLUSIONS
We have reviewed only a few of the most standard nominal and real
term structure models within the affine framework, and discussed
recent empirical evidence regarding the performance of these models. Identification issues and liquidity problems in the TIPS market (clearly evident during the financial crisis of 20089) were also
discussed. In addition, we have summarised the estimates of inflation expectations and inflation risk premium that real term structure
models have produced.
Although, as discussed in detail, different papers take distinct
approaches to the study of this topic and, in particular, to the identification of the several components of real and nominal yields, the
key conclusion is that, in the US, both inflation expectations and
inflation risk premiums have been diminishing and well behaved,
in line with the Federal Reserve dual mandate to foster maximum
employment and in the context of price stability.
APPENDIXES BY STEFANIA A. PERRUCCI12
Bond prices are expectations under the risk-neutral measure
In the absence of arbitrage, bond prices Pt, discounted by the appropriate numeraire Nt are martingales under the risk-neutral measure
Q. That is
Q
1
1
Pt+ ,0 ] = Et [Nt+
1]
Nt1 Pt, = Et [Nt+
(10.1)
Choosing the money market (the cash bond) as the numeraire

Nt = exp
t
0
rs ds
(10.2)
the dynamics of the short rate rs determines the whole term structure,
ie, the entire zero-coupon yield curve yt,
Pt, = exp[yt, ] =
Q
Et
t+

exp
rs ds
t
(10.3)
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The market price of risk

Astandard functional assumption for the discrete one-period change
in measure is the exponential form
t+1
= exp( 12 Tt t Tt BPt+1 )
t
(10.4)
where t is an N-dimensional vector, also called the price of risk,

and BPt+1 is a standard (zero drift) N-dimensional Brownian motion
under the physical measure P. In continuous time, this corresponds
to the following differential equation
dt = t Tt dBPt
(10.5)
t+
t+

t+
1
= exp
Ts s ds
Ts dBPs
2 t
t
t
(10.6)
which has the solution
If BPt is a standard (zero drift) Brownian motion under P, then it can

be shown that
BPt +
t
0
s ds = Bt
(10.7)
Q
dBPt + t dt = dBt
(10.8)
or, in discrete time

Q
BPt + t1 = Bt
(10.9)
is a standard Brownian motion under the risk-neutral measure Q. In

other words, BPt has zero drift under P, but it acquires instantaneous
drift t under Q.
Zero-coupon bond prices under both measures
Bond prices can be calculated under either the risk-neutral measure
or the physical measure, after adjusting for the appropriate change
in probability density. Under the former
Pt, =
Q
Et
t+

exp
rs ds
t
(10.10)
Under the physical measure

Pt, =
EPt
t+

t+
Mt+
exp
rs ds = EPt
t
Mt
t
(10.11)
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where the nominal pricing kernel Mt is defined as

t
Mt = t exp
rs ds
(10.12)
Using the exponential form for the change in probability measure

introduced in the previous appendix, the pricing kernel satisfies the
stochastic differential equation
dMt
= rt dt Tt dBPt
Mt
(10.13)
The price of a zero-coupon bond is then given by

Pt, =
EPt
1
exp
2
t+
t
Ts s
ds
t+
t
Ts
dBPs
t+

rs ds
exp
t
t+
t+

1
def P
= Et exp
Ts s ds
Ts dBPs
2 t
t

t+

P
rs ds
Et exp
t
t+
t+

1
P
T
T
P
+ covt exp
s s ds
s dBs ,
2 t
t
t+

exp
rs ds
t
(10.14)
where the last equality follows from the very definition of covariance. We define
t,
1
= exp
2
def
t+
t
Ts s
ds
t+
t
Ts dBPs
(10.15)
Then we can rewrite the price of a zero-coupon bond as follows

Pt, =
t+

exp
rs ds
t

t+

+ covPt (t, ), exp
rs ds
EPt [t, ]EPt
(10.16)
This equation can be used to calculate bond prices given the specification of the short rate and the price of risk under the physical
measure P.
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Calculations of zero-coupon bond prices

As an example of the equivalency of using either probability measure, we now consider a zero-coupon bond. Working again in discrete time for simplicity, the time-t price of a one-period bond is
given by (under the risk-neutral measure Q)
Q
Pt,1 = Et [exp(rt )] = exp(rt )
(10.17)
The same result can be obtained working under the physical measure
P as follows
Pt,1 = EPt
t+1
exp(rt )
t
= exp(rt 2 Tt t )EPt [exp(Tt BPt+1 )]

1
1
= exp(rt 2 Tt t ) exp(+ 2 Tt t )
= exp(rt )
(10.18)
The term premium

The bond term premium Tt, is the compensation required to bear
the interest rate risk. It can be defined as the difference between the
nominal yield and the yield we would obtain if the price of risk were
zero
Tt, = yt, yt, (s = 0)

t+
1
rs ds
= yt, + ln EPt exp
t
Tt, =
ln(EPt [t, ])
1
ln 1 +
covPt [t, , exp(
t+
EPt [t, ]EPt [exp(
rs ds)]
t t+
t
(10.19)
rs ds)]
(10.20)
Clearly, the bond term premium depends on the functional form of

the price of risk s , and it is zero if the price of risk is zero. Note that
if bonds yields are affine, then the term premium will also be affine.
Bond prices in discrete time
Given a bond with time to maturity at time t, ie, Pt, will have time
to maturity 1 at t + 1, we obtain the following recursive relation
Q
Pt, = Et [exp(rt )Pt+1,1 ]

=
EPt
t+1
exp(rt )Pt+1,1
t
(10.21)
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In discrete time, the nominal pricing kernel is defined as

mN
t+1 =
t+1
exp(rt )
t
(10.22)
and the nominal zero-coupon bond price is given by

Pt, = EPt

i =1
mN
t+i
(10.23)
Bond expected n-period return

Consider the zero-coupon bond price Pt, at time t. The continuously
compounded return of such a bond over n periods (n ) is given
by

Pt+n,n
1
1
1
= ln Pt+n,n ln Pt,
ln
(10.24)
n
Pt,
n
n
Its expectation value at time t is given by

t,n =
Pt+n,n
1 P
Et ln
n
Pt,

=
1 P
Et ln[Pt+n,n ] + yt,
n
n
(10.25)
We typically compare the expected return over the n-period holding

window with the (expected) return of the n-maturity zero-coupon.
The n-period excess return for the zero-coupon bond is then defined
as follows
t,n yt,n =
1 P
Et ln[Pt+n,n ] + yt, yt,n
n
n
(10.26)
Consider the simple autoregressive affine model with constant

volatility. In this model, the price of zero-coupon bonds is exponentially affine and given by
Pt, = exp[yt, ]
= exp(A + BT Xt )
(10.27)
Pt+n,n = exp[yt+n,n ( n)]

= exp(An + BTn Xt+n )
(10.28)
Furthermore, since the drift of the state vector is affine, ie

Xt = + Xt1 + Brownian motion
(10.29)
the expectation of Xt+n conditional to time t

EPt [Xt+n ] = n + n Xt
(10.30)
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is also affine, where

(1 n )
1
n =
and n = n
(10.31)
As a consequence, the expected n-period excess return is affine in

the state variables
An A + An + BTn n (BTn n BT + BTn )Xt
+
n
n
(10.32)
For example, if we take the holding period to be n = 1, the above
expression becomes
t,n yt,n =
t,1 yt,1 = (A1 A + A1 + BT1 ) + (BT1 BT + BT1 )Xt

= BT1 0 12 BT1 T B1 + BT1 X Xt
(10.33)
This shows that a deterministic price of risk (X = 0) cannot

reproduce stochastic expected excess returns.
Constant volatility AR(1) affine model
Within the class of affine models, we consider the simple affine
AR (1) diffusion introduced before, with the constant N N volatility matrix (not dependent on the state variables, although it might,
in more general specifications, depend on time)
Xt = + Xt1 + BPt
(10.34)
TX Xt
(10.35)
t = 0 + X Xt
(10.36)
rt = 0 +
We will work in discrete time in order to deal with finite difference equations rather than differential equations. Introduced in the
appendix on page 238, the following relation
Pt, =
EPt
t+1
exp(rt )Pt+1,1
t
(10.37)
can help us build the whole yield curve at time t, starting from
the one-period short rate rt . Furthermore, since this rate is assumed
to be affine in the state vector, this property clearly extends to the
whole yield curve, thanks to the recursive expression above. In fact,
suppose Pt,1 is exponentially affine, ie
Pt,1 = exp(A1 + BT1 Xt )
(10.38)
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Then, recalling the expression for the change in probability density

introduced in Equation 10.4 we have
Pt, = EPt
t+1
exp(rt )Pt+1,1
t
= exp(rt 12 Tt t + A1 )
EPt [exp(Tt BP1 + BT1 Xt+1 )]
= exp(rt 12 Tt t + A1 )
EPt [exp(Tt BP1 + BT1 Xt+1 )]
1
= exp(rt 2 Tt t + A1 + BT1 + BT1 Xt )
EPt [exp[(Tt + BT1 )BPt+1 ]]
(10.39)
where the following relation has been used to arrive at the last
equality
Xt+1 = + Xt + BPt+1
(10.40)
The expectation of the exponential of the Brownian motion is

easily calculated as
EPt [exp[(Tt + BT1 )]BPt+1 ]
= exp( 12 Tt t + 12 BT1 T B1 BT1 t )
(10.41)
Note the quadratic terms in the price of risk cancel out, so we are
left with
Pt, = exp(rt + A1 + BT1 + BT1 Xt
+ 12 BT1 T B1 BT1 t )
(10.42)
which is clearly exponentially affine as long as the short rate rt , the

process variance T , its drift + Xt and t are exponentially
affine. Specifically
Pt, = exp(A + BT Xt )
(10.43)
where, after rearranging terms

A = 0 + A1 + BT1 ( 0 ) + 12 BT1 T B1
(10.44)
BT
(10.45)
TX
BT1 (
X )
with initial conditions A0 = 0 and BT0 = 0.

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Real bonds, indexed bonds and TIPS

The barter economy and basket-denominated zero-coupon bonds
We can imagine a barter economy where contracts are specified in
terms of a basket of good and services. In other words, the zerocoupon bond in the barter economy promises one unit of the consumption basket at maturity in exchange for a fraction of the basket today. Assuming the barter economy is complete and there are
no arbitrage opportunities, after specifying a numeraire, there will
be a unique risk-neutral probability measure QR under which all
basket-denominated tradeable instruments of the barter economy
are martingales. For the zero-coupon bonds, paying one unit of the
consumption basket at maturity, we have the expressions
QR
Pt,R = Et
t+
exp
Pt,R = EPt
rsR ds
MtR+
MtR
= EPt
t+

tR+
R
exp
r
ds
s
tR
t
(10.46)

= [exp(yt,R )]
QR
dBPt + Rt dt = dBt
(10.47)
(10.48)
The dollar economy and no-arbitrage condition between pricing

kernels
In the dollar economy, the basket-denominated bond Pt,R is not a
tradeable instrument, but its dollar value Qt Pt,R is. Therefore, to
avoid arbitrage, the dollar value of the real bond discounted by the
nominal money market numeraire must be a QN martingale
QN
QN
1
1
Nt1 Qt Pt,R = Et [Nt+
Qt+ PtR+ ,0 ] = Et [Nt+
Qt+ ]
(10.49)
or in the data-generating probability measure

Pt,R = EPt
= EPt
=
EPt
t+

tN+
Qt+
N
exp
r
ds
s
Qt
tN
t
N

Mt+ Qt+
MtN Qt
MtR+
MtR
(10.50)
Therefore, no arbitrage requires that pricing kernels are such that

MtR = MtN Qt
(10.51)
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Dollar-denominated indexed zero-coupon bonds

Consider the dollar-denominated zero-coupon bond Ptindexed
index0 ,t,
ed to the price index Qt , starting at t0 t, maturing at time T = t + .
At maturity, its dollar payout is
Ptindexed
=
0 ,t+ ,0
Qt+
Qt0
(10.52)
Therefore, in the dollar (nominal) risk-neutral probability measure

QN , its price at time t is given by
Ptindexed
0 ,t,
=
=
QN
Et
t+

Qt+
N
exp
rs ds
Qt QN
E
Qt0 t
Qt
Qt0
Qt
Qt0
Qt
t+

Qt+
N
exp
rs ds
t
t+
tN+
EPt
exp
rsN
tN
t
N

Mt+ Qt+
EPt
MtN Qt

Qt
ds
Qt+
Qt
(10.53)
That is, using the no-arbitrage condition

=
Ptindexed
0 ,t,
Qt R
P
Qt0 t,
where
(10.54)
QN
dBPt + N
t dt = dBt
(10.55)
Inflation-linked zero-coupon bonds

Note that the indexed zero-coupon bond is different from the zerocoupon TIPS, as the latter includes a three-month indexation lag and
also a deflation floor. The indexation lag is an interpolation between
a three-month lag and a two-month lag, but, for simplicity, we will
assume that we observe TIPS prices and yields on the last business
day of the month (for settlement T + 1 on the first day of the following
month), so that the interpolation lag in the daily price index is exactly
three months. Thus, the TIPS principal payout at maturity is

PtTIPS
=
0 ,t+ ,0
Qt+3M
Qt+3M
+ max 1
,0
Qbase
Qbase
(10.56)
where Qbase is the index base value (see Chapter 7). Typically, the
value of the deflation floor is neglected when computing zerocoupon TIPS yields. This introduces a negative bias to real yields calculated without including the floor, although it could be argued that,
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at least historically, the liquidity effect, which acts in the opposite

direction, has dominated
= EPt
PtTIPS
0 ,t,
MtN+ Qt+3M
MtN Qbase
Qt P MtN+3M Qt+3M MtN+

=
E
Qbase t
Qt
MtN
MtN+3M

=
PtTIPS
0 ,t,
Qt
MtN+
Pt,R3M EPt
Qbase
MtN+3M
+ covPt
Qt R
MtN+
Pt,3M EPt
Qbase
MtN+3M
1 +
covPt
If we define
lagt, =
ln EPt
(10.57)
MtN+3M Qt+3M MtN+

, N
Qt
MtN
Mt+3M

MtN+3M Qt+3M MtN+

, N
Qt
MtN
Mt+3M

N
Mt+
R
P
Pt,3M Et
MtN+3M
MtN+
MtN+3M
covPt
1
ln
1+

(10.58)
MtN+3M Qt+3M MtN+

, N
Qt
MtN
Mt+3M

N
Mt+
Pt,R3M EPt
MtN+3M
(10.59)
and since (see Chapter 7)
Qbase TIPS
TIPS
P
= exp[yt,x
]
Qt t0 ,t,
(10.60)
we then have
R
yt,TIPS
= yt,3M + lagt,
(10.61)
yt,R3M = yt,TIPS
lagt,
(10.62)
The index process

Let Qt represent the stochastic evolution of a price index under the
real world probability measure P
Qt+
= exp
Qt
t+
t
is ds + QT (BPt+ BPt )
(10.63)
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where Q is an N 1 vector. The presence of the Brownian motion

term QT (BPt+ BPt ) in the exponential might (or might not) come as a
surprise. In fact, we could model the price index without an explicit
Brownian motion term, by simply allowing is to be a function of
the stochastic state variables. However, the model above is more
general and allows for a better fit to the implied volatility surface
of both nominal rates options and inflation options (not the focus of
this chapter but still the reason why such a model is predominant).
The price index above satisfies the stochastic differential equations13
dQt
= (it + 12 QT Q ) dt + QT dBPt
Qt
(10.64)
d ln Qt = it dt + QT dBPt
(10.65)
or, alternatively
Note that
Qt
=
ln
Qt+
and
EPt
t+
t
is ds QT (BPt+ BPt )
Qt
ln
Qt+

=
EPt
(10.66)
t+
t
is ds
(10.67)
The price index might represent, for example, the US Consumer

Price Index, while is can be interpreted as the instantaneous rate of
inflation.
Real term premium and inflation premium
Real bond yields and real term premium
Similarly to the appendix on page 236 for nominal bond prices,
we can derive an analogous relation for basket-denominated zerocoupon bond prices

t+
Pt,R = EPt [Rt, ]EPt exp
rsR ds
t+

+ covPt Rt, , exp
rsR ds
t

t+

P
R
P
R
rs ds
= Et [t, ]Et exp
t
t+

covPt [Rt, , exp( t rsR ds)]
1+ P R

t+
Et [t, ]EPt [exp( t rsR ds)]

(10.68)
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where Rt, is a function of the price of real risk, similar to that defined
previously. If we introduce a real yield term premium as
Tt,R =
ln(EPt [Rt, ])
ln 1 +
covPt [Rt, , exp(
t+
EPt [Rt, ]EPt [exp(
rsR ds)]
t+
t
(10.69)
rsR ds)]
we can derive the real bond yields

t+
1
yt,R = EPt exp
rsR ds
+ Tt,R
(10.70)
Finally, if we define the integral

It,R =
t+
t
rsR ds
(10.71)
we can write the real yield as a sum of the -period expectation of

the instantaneous real rate, plus a Jensen inequality term, plus the
real term premium
yt,R =
EPt (It,R ) +
ln EPt [exp(It,R )] +
EPt (It,R ) +Tt,R

Jensens term
(10.72)
If we assume It,R is normally distributed conditional to information at time t (ie, an affine model), then we can explicitly calculate
the Jensen term and we have
EPt [exp(It,R )] = exp[EPt (It,R ) + 12 vart (It,R )]
ln EPt [exp(It,R )] = EPt (It,R ) + 12 vart (It,R )
Therefore
yt,R =
EPt (It,R )
1
vart (It,R ) + Tt,R
2
(10.73)
(10.74)
(10.75)
where the first term on the right-hand side represents the -period
expectation of the instantaneous real rate at time t, the second term
is the Jensen inequality term and the last term is the real rates term
premium.
Nominal yields and the inflation risk premium
We have already derived nominal yields and term premium in a
previous appendix, but here we express these in terms of real yields,
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inflation expectations and inflation risk premium

Pt,N = EPt
= EPt

MtN+
MtN
= EPt
MtR+ Qt
MtR Qt+
MtR+ P Qt
Et
Qt+
MtR
= Pt,R EPt
= Pt,R EPt
yt,N = yt,R
Qt
Qt+
Qt
Qt+
EPt
+ covPt

1+
Qt
Qt+
+ covPt

MtR+ Qt
,
MtR Qt+
MtR+ Qt
,
MtR Qt+
covPt [MtR+ /MtR , Qt /Qt+ ]

Pt,R EPt [Qt /Qt+ ]
ln 1 +
(10.76)


Pt,R EPt [Qt /Qt+ ]
(10.77)
The Jensen term can be identified as follows

ln EPt
Qt
Qt+

Qt
Qt
Qt
= EPt ln
+ ln EPt
EPt ln
Qt+
Qt+
Qt+

Jensens term
(10.78)
The inflation risk premium, IRPt, , is given by
IRPt, =
ln 1 +

Pt,R EPt [Qt /Qt+ ]
(10.79)
Note that the inflation risk premium is positive if there is negative

covariance between the price index and the real pricing kernel.
Since
t+

Qt
1
1
1
= EPt
EPt ln
is ds = EPt [It,inf
]
Qt+
(10.80)
we have
yt,N = yt,R +
EPt
t+
t
ln EPt
is ds
Qt
Qt+
EPt
Qt
ln
Qt+

+ IRPt,
(10.81)
Jensens term
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Collecting the two (real rate and price index) Jensens terms
together
1
1
Jensent, = EPt [exp(It,R )] EPt (It,R )
ln EPt
Qt
Qt+

Qt
1
+ EPt
ln
Qt+
(10.82)
so that
yt,N =
1
EPt (It,R ) +

EPt [It,inf
]
expectations
Tt,R

real term premium
IRPt,

+ Jensent,
(10.83)
inflation premium
Affine models of both real and nominal term structures

The nominal term-structure pricing kernel
dMtN
P
= rtN dt NT
t dBt
MtN
(10.84)
QN
BPt + N
t dt = dBt
(10.85)
where QN is the nominal risk-neutral probability measure, under

which discounted zero-coupon nominal bonds are martingales, and
NT
rtN = N
0 + X Xt
(10.86)
N
t
(10.87)
N
0
NT
X Xt
The real term-structure pricing kernel

dMtR
P
= rtR dt RT
t dBt
MtR
(10.88)
QR
BPt + Rt dt = dBt
(10.89)
where QR is the real risk-neutral measure that makes discounted

zero-coupon basket-denominated bonds martingales, and
rtR = R0 + RT
X Xt
(10.90)
Rt
(10.91)
R0
RT
X Xt
Under the data-generating measure P, the pricing index satisfies

Qt+
= exp
Qt
t+
t
is ds + QT (BPt+ BPt )
(10.92)
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where the instantaneous inflation is also assumed to be an affine

function of the state variables
it = i0 + iXT Xt
(10.93)
In this simple formulation, inflation is driven by the same three

factors that drive the nominal and real yields. However, we might
easily include additional imperfectly correlated (or uncorrelated)
factors into the model.14
Nominal and real term structure parameters
Using the no-arbitrage relation between pricing kernels
MtR = MtN Qt
(10.94)
and, applying Its lemma

N
dMtR = MtN dQt + Qt dMtN NT
t Q Mt Qt dt
(10.95)
we can relate the real and nominal parameters as follows

dQt dMtN
dMtR
+
NT
t Q dt
R =
Qt
Mt
MtN
(10.96)
P
T
T
P
N
rtR dt RT
t dBt = (it + 2 Q Q ) dt + Q dBt rt dt
1
P
NT
NT
t dBt t Q dt
(10.97)
so that
rtR = rtN (it + 12 QT Q ) + NT
t Q
(10.98)
Rt
(10.99)
N
t
Thus,
i
T
NT
R0 = N
0 0 2 Q Q + 0 Q
(10.100)
RX
R0
RX
NT
X Q
(10.101)
=
=
=
N
X
N
0
N
X
iX
(10.102)
(10.103)
Note that we have been working under the data-generating probability measure, where the price index satisfies
dQt
1
= (it + 2 QT Q ) dt + QT dBPt
Qt
(10.104)
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However, by using the following relations

rtN rtR = (it + 12 QT Q ) NT
t Q
Q
dBPt = dBt
N
t dt = dBt
(10.105)
Rt dt
(10.106)
we can derive the price index evolution under the two (nominal and
real) risk-neutral measures
dQt
QN
= (rtN rtR ) dt + QT dBt
Qt
QR
= (rtN rtR + QT Q ) dt + QT dBt
(10.107)
We thank Stefania Perrucci for very detailed and helpful comments

and suggestions that have helped to improve this chapter significantly. We also thank Min Wei and Refet Gurkaynak for helpful
discussions and comments. The views expressed here are solely
those of the authors and do not necessarily reflect the concurrence
by other members of the research staff or the Board of Governors
of the Federal Reserve System.
1
Equivalent probability measures agree on what is possible. In other words, impossible events
will have zero probability under both measures, and possible events will have different but
positive probabilities for both measures.
In particular, only a number of yields equal to the number of latent factors can be exactly fitted
at all points in time (for example, three yields can be exactly fitted in a three-latent-variable
model).
Latent factors refer to their lack of further interpretation, although there are cases where a
macroeconomic identification might be possible.
In other words, the ideal model should be flexible enough to capture the term-structure
dynamics, and yet remain mathematically tractable.
Note that in many older treatments of this topic, real yields were assumed constant, and
therefore nominal yields changes were simply driven by changes in inflation expectations
(the risk premium is obviously zero in this case). This is partly due to the fact that real yields
are observable (lags and liquidity premium consideration aside) only in countries where
a government inflation-linked market is developed, so the empirical study of real yields
dynamics has in many cases been limited by the availability of data.
In a later paper (Ang et al 2005), the Taylor rule includes only one latent factor contemporaneously uncorrelated with growth and inflation. The latter assumption is reasonable (as growth
and inflation will react with a lag to monetary shocks), and allows for unbiased (albeit not
efficient) ordinary least square estimation of the coefficients in the Taylor equation.
Grishchenko and Huang (2010) estimate that this effect does not exceed four basis points in
terms of the real yield. In addition, inflation-linked bonds also have duration risk.
Here and later, we refer to real term structure models as models that include the dynamics of the instantaneous real rate and the instantaneous inflation, expected inflation or the
instantaneous nominal rate.
To be precise, there is both a risk premium (covariance term) and a Jensens inequality term
(variance term).
10 See http://www.phil.frb.org/ and http://www.aspenpublishers.com.
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11 Internal estimates by the Federal Reserve Board staff.

12 Stefania would like to thank Lars Tyge Nielsen for helpful comments and review.
13 Other treatments of the topic put the variance term in the price index expression, so that it
disappears in the stochastic differential equation.
14 For an example, see DAmico et al (2009).
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Ang, A., G. Bekaert and M. Wei, 2008, The Term Structure of Real Rates and Expected
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Barr, D. G., and J. Y. Campbell, 1997, Inflation, Real Interest Rates, and the Bond Market:
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Buraschi, A., and A. Jiltsov, 2005, Inflation Risk Premia and the Expectation Hypothesis,
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Campbell, J., and R. Shiller, 1991, Yield Spreads and Interest Rate Movements: A Birds
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Campbell, J., R. Shiller and L. M. Viceira, 2009, Understanding Inflation-Indexed Bond
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Cox, J., J. Ingersoll and S. Ross, 1985, A Theory of the Term Structure of Interest Rates,
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11
Monetary Policy, Inflation and

Commodity Prices
Frank Browne, David Cronin

Central Bank of Ireland
The interaction between commodity prices, general inflation and

monetary policy has re-emerged in recent years as a topic of interest
among academic economists, central bankers and financial market
participants alike. A sustained, broadly based increase in commodity prices started in the mid 2000s, and rising prices have also been
evident in other major asset classes (stocks, bonds, property). These
price increases occurred against a monetary policy stance, in the
major advanced industrial countries, that was viewed as broadly
accommodating in many quarters at that time, and as being appropriate given that general inflation rates, eg, consumer price index
(CPI) inflation rates, were relatively low, and within or close to targets set for, or by, central banks. Moreover, rising commodity prices
were not seen as having any substantial impact on consumer prices.
Most asset prices started to decline in late 2007. Commodity prices
fell rapidly and steeply in the second half of 2008. Ironically, this
occurred against a background of policy interest rates being reduced
to close to zero, and an unconventional monetary policy tool, quantitative easing, being introduced by the main central banks. Since then,
and against a background of a continuing accommodative monetary
policy stance, commodity prices have regained upward momentum.
While the pick-up in commodity prices since 2009 has had an
effect on the headline consumer inflation rate, its core inflation
component, as measured by headline CPI inflation minus its food
and energy components, remains close to acceptable values in the
major developed countries. Commodity price developments, then,
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do not seem to be translating into a broadly based effect on consumer

prices, in contrast to the 1970s and early 1980s. This feature of recent
data, and indeed the ability of core inflation to remain anchored at
low values through the 1990s and the 2000s regardless of the shocks
hitting the economy, has been attributed to the adoption of a monetary policy framework, inflation targeting, that has as one of its main
goals stopping one-off price pressures becoming embedded in inflation expectations. Of course, another factor behind the diminishing pass-through from commodity prices to consumer prices is the
smaller role that raw materials, most notably oil, play in economic
activity in modern developed economies.
It is, nevertheless, now clear that the inflation-targeting framework has been found wanting. It did not provide any advance warning of the effect of collapsing bubbles or the massive deflationary
forces unleashed as a consequence. This stemmed, in our view, from
its neglect of the role of asset prices, as well as the vast changes
that have occurred in the financial system since roughly the mid
1990s, which have enhanced the substitutability between money and
financial assets.
This short overview points to the need to examine a number of
specific issues in seeking to improve our understanding of the nexus
between commodity prices, CPI inflation and monetary policy. Setting an explicit numerical target for inflation, or at least a target of
low and stable inflation, plays a critical role in monetary policy at the
time of writing. This practice of inflation targeting anchors price
expectations, by requiring central banks to set out their inflation
target and how they intend to achieve it, and holding them accountable for meeting that target. As well as explaining the rationale for
and practice of inflation targeting, we also provide an overview of
criticism of this monetary policy strategy, in particular, versions of
it that ignore developments in financial markets and in money and
credit variables. This strategy meant that central banks, by remaining
steadfast to inflation targeting in the face of imbalances and distortions evident in asset markets, contributed to the financial crisis that
was precipitated in 2007.
The challenges in addressing and rectifying the current difficulties
in financial markets, and the wider economy, are acute for leading
central banks, such as the Federal Reserve and the European Central
Bank. Policy interest rates are close to zero, thus limiting their scope
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MONETARY POLICY, INFLATION AND COMMODITY PRICES
as instruments of monetary policy. As discussed later, one policy

innovation brought in in response to the loss of leverage from conventional monetary policy instruments has been quantitative easing.
In increasing the amount of liquidity in the economy, and in reducing
the yield on a competing asset class, government bonds, quantitative
easing may have stoked the surge in commodity prices since 2009.
It may also be that a super-cycle is present in commodity markets, with rising prices therein not a temporary phenomenon but
part of a long period of sustained high commodity prices. This is
owing to countries such as China and India emerging as industrial
superpowers, leading to an increased demand for commodities as
industrial inputs, and in building up capacity in those economies.1
At the same time, there appears to be a stronger co-movement in
the prices of different commodities. This suggests that there may be
common factors at play in commodity markets. One such possibility is that the growing treatment of commodities as a separate asset
class, and their being added to asset portfolios as a means of reducing the risk of those portfolios, may have increased co-movement in
their prices.
Another viewpoint, discussed in detail later in this chapter,
stresses the capacity of commodity prices in general to respond
quickly to changes in monetary policy and, indeed, to overshoot
equilibrium values, so as to maintain overall prices in the economy
in line with the level of the money stock (Frankel 2008; Browne and
Cronin 2010). High commodity prices then can occur in response
to loose monetary policy conditions, such as have existed since the
early 2000s, and are consistent with a low CPI inflation rate in the
short-to-medium term, with that inflation rate rising subsequently.
INFLATION-TARGETING AND MODERN MONETARY
POLICYMAKING
The 1970s and early 1980s proved to be difficult times for central
banks. High inflation rates and low, and even on occasion negative,
growth rates (a phenomenon known as stagflation) were a feature
of the economic environment in many Western countries. Cost-pushrelated policy measures (direct control of wage and price increases)
were pursued in the 1970s to address this malaise, but were unsuccessful in bringing inflation down from high rates. Later, however,
a form of the quantity theory of money,2 labelled monetarism and
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most closely associated with economist Milton Friedman, came to

form the basis for reducing inflation. The so-called Volcker disinflation (named after the former Federal Reserve chairman) in the US
saw the Federal Reserve aggressively raise interest rates in the early
1980s, with inflation subsequently declining.
The intervening quarter of a century, up to the late 2000s, saw a
decline in inflation rates to low single-digit figures, occurring alongside generally buoyant economic growth. Furthermore, the variability of inflation, and output growth rates, fell progressively. While
there is an acknowledgement that good luck in the form of fewer
large shocks, such as oil price shocks, played its part, it is commonly
accepted that improvements in macroeconomic policy, in particular, monetary policy, were central to the economic stability and
prosperity achieved during this period.
As might be expected, the negative experiences of the 1970s stimulated a lot of research in how monetary policy could be improved in
practice. Among the earliest advances in that research was the identification of structural credibility problems in the conduct of monetary policy. Specifically, it was found that rules were better than
discretion in guiding policy. Adherence to rules leaves the public
more assured as to how the central bank conducts itself and, accordingly, guides its own expectations and behaviour that are, in turn,
key to the success of monetary policy. In practice, rules-based monetary policy was supported by the granting of independent statutes
to central banks. This often included specific inflation targets to be
achieved. In essence, three Cs came to underlie central banking:
credibility, consistency and continuity (Stark 2007).
A clear focus on the need to maintain price stability became the
centrepiece of central banks activities. Through the late 1980s and
into the 1990s, central banks were increasingly successful at achieving price stability. With inflation reduced to moderate levels, and
their standing high, central banks faced a new set of challenges in
the 1990s. First, having reduced inflation, over the previous 10 years
or so, to low levels, central banks now needed to maintain inflation rates close to the price stability benchmarks explicit or implicit
in their statutes. Secondly, the high standing of central banks meant
that their statements and comments were carefully scrutinised by the
public. Communication was vital to the success of monetary policy,
and openness and transparency were recognised as key elements of
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the communication policy. At the same time, central banks had to be

careful and precise in explaining their monetary policy actions and
intentions, so that the public would not misinterpret, or be confused
about, what was being said.
A number of concurrent developments in academic research and
policy analysis seemed to provide a means of conducting and communicating monetary policy. Explicit numerical inflation benchmarks were often set for, or by, central banks, and those inflation
targets became the focal point of decision-making. The Taylor Rule
(Taylor 1993), named after its proposer, Professor John Taylor, was
initially used as a descriptive tool, but was promoted in some circles as a means of setting monetary policy. Under this rule, the
central bank would mechanically set the short-term interest rate
as a function of the deviation of the actual inflation rate from its
target rate and the deviation of output (GNP/GDP) growth from
its long-run potential growth rate. The Taylor Rule became one of
the three key elements of the so-called New Keynesian model
of the economy, which offered, according to its advocates, a parsimonious, but integrated and realistic, description of aggregate
demand and inflation determination. Even where central banks
do not explicitly follow the Taylor Rule, it is accepted as playing
a prominent role in how many go about devising their monetary
policy stance.
There is no need for a money demand function or, indeed, for any
money variable within the inflation-targeting paradigm. Instead,
inflation is seen as originating in the labour market rather than
in money markets. A version of the Phillips curve,3 where the size
of the output gap indicates inflationary pressures within the economy, plays an important analytical role in the inflation-targeting
approach. These developments in macroeconomic modelling happened to coincide with increased difficulties in assessing and forecasting the publics demand for holding money balances. In the US
especially, where the New Keynesian perspective is particularly popular among academics, financial innovation and liberalisation made
it difficult to model the demand for money successfully. The development of near-money substitutes, such as mutual funds, made it
hard to ascertain the publics demand for money if it shifted its liquid
wealth between money and near-money assets. Consequently, the
information coming from the monetary sphere was not as helpful
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to monetary policy formulation as previously. Accordingly, what

could be termed economic analysis, ie, analysis focusing on the
real economy, became increasingly stressed as the basis for monetary policy decision-making. Aggregate demand (and its components), potential output/aggregate supply, unemployment and
inflation expectations are the key variables to be assessed in this
sphere.
Inflation targeting appears to have been a success, at least in terms
of inflation performance. In a review of emerging market economies,
the International Monetary Fund (2005) found that those countries
that followed an inflation-targeting approach had a better inflation
performance than non-targeting countries, in terms of both average
inflation rates and volatility of those rates. Habermeier et al (2009)
found that inflation-targeting countries appear to have done better
than others in minimising the inflationary impact of the 2007 surge
in commodity prices.
This approach has benefited the investment community. The
forward-looking approach taken by central banks to assessing inflationary pressures, their willingness to disclose publicly the basis
for their monetary policy decisions, and their determination to
ensure any price developments do not become embedded in inflation expectations, have provided investors with confidence that
swings in inflation rates are not likely to impact on financial outturns. Furthermore, to the extent that price stability leads to a better allocation of resources in the economy (one of the main rationales for its pursuit), the waste that is thereby obviated should
accrue to investors in the form of an enhanced risk-adjusted rate
of return.
The culmination of events in the new millennium, however, has
seen the inflation-targeting approach to monetary policy come under
the spotlight. Most importantly, the question arises as to whether
inflation targeting itself played a role in the shocks and events that
have affected developed economies severely. Advocates of inflation
targeting do not see monetary policy having to react to changes
in asset prices, other than to use any information they may provide as to how final goods inflation rates will develop over time.
Likewise, as long as central banks remain focused on the long-term
path of the inflation rate, and maintain it close to target values,
periodic variations in headline inflation rates owing to commodity
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prices are not of great concern. The credibility afforded to monetary policy by inflation targeting can also diminish economies vulnerability to the inflationary impact of commodity price shocks,
by ensuring those shocks do not become embedded in expected
inflation.
The narrow focus on the real economy and performance associated with inflation targeting nevertheless means that important
information concerning developments in money and financial market variables may have been ignored in setting monetary policy.
Moreover, inflation targeting operates through one policy variable:
the central bank policy interest rate. Whether that interest rate is a
sufficiently robust instrument in avoiding or addressing major disturbances to economic and financial performance is open to question. Taylor (2009) apportions part of the blame for the financial crisis
that emerged in 2007 to monetary policy having pursued persistently
low interest rates for an extended period. He suggests that monetary excesses were the main cause of the boom and subsequent
bust that occurred in the mid 2000s (Taylor 2009, p. 2).
While inflation targets were being met in most developed countries during the mid 2000s, monetary policy, mainly through the
provision of cheap credit, was contributing to excessive risk-taking
in financial markets, and an over-pricing of financial and real assets
such as property. Eventually, this led to substantial falls in asset
prices, as well as the threat of deflation hanging over Western
economies. The inflation-targeting framework could not have foreseen this, because of its belief in the second-order importance of asset
markets for monetary policy.
Besides raising potential issues for the maintenance of price stability, an accommodative monetary policy stance, if maintained over
a long period, can pose a threat to financial stability. This view that
financial imbalances, especially excess money and credit growth,
brought about by monetary policy pose a threat to the well-being
of economies was most prominently expressed by Bank for International Settlements (BIS) economists (see, for example, Borio and
Lowe 2002; Borio and White 2004) in the years leading up to the
financial crisis. They argue that the simultaneous development of
imbalances in monetary variables, such as credit, and in asset prices
should be of concern to central banks. Financial liberalisation and
innovation can generate such imbalances and encourage greater
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procyclicality in financial markets. This can occur against a background of low and stable inflation. Excess demand can show up
first in asset prices rather than consumer prices, which may explain
why financial imbalances and rising asset prices occur in a lowinflation environment. The concerns expressed by BIS and other
economists underline the need for central banks to monitor monetary and financial developments, as well as those in the real economy,
closely.
MONETARY POLICY IN THE FINANCIAL CRISIS
Inflation targeting, which seemed to do a good job in the not too
distant past, has been found wanting. As others have noted (see, for
example, Canuto 2009), well-behaved inflation and output performance, which were features of advanced industrial economies leading up to the crash, are no guarantee against a dangerous upward
asset price spiral developing and then collapsing, with enormous
implications for the central bank and its ability to maintain a stable
monetary and financial system.
In the wake of the financial crisis, central banks, faced with either a
liquidity trap or the zero lower bound on nominal interest rates, had
to turn to using an alternative policy instrument, quantitative easing.
This was utilised because nominal interest rates were already close
to zero, and thus the scope for reducing them further was limited.
Quantitative easing involves proactively buying up a large fraction
of the stock of government bonds, at whatever price is needed for
holders to be willing to engage in exchange. Its purpose is to accommodate the need for liquidity in financial markets, and the economy
more generally.
It goes beyond, however, a normal accommodating monetary policy, which tends to occur at a positive value for the nominal rate of
interest, when the central bank makes funding available in infinitely
elastic amounts at that rate (subject to good collateral). The difficulty
with conventional monetary policy is that the amount of liquidity
injected into the financial system may be deemed to be inadequate,
even with full accommodation and at a zero rate of interest, in the
type of distressed state in which financial markets found themselves
in the wake of the financial crisis. This is where the need for quantitative easing comes in. It involves purchasing what has turned
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out to be an extremely large amount of government securities outright, as a way of injecting liquidity into the banking system, with
the ultimate objective of kick-starting the economy, and obviating
deflation.
Quantitative easing was employed by the Bank of Japan during
the early-to-mid 2000s in its attempts to tackle deflation in the
Japanese economy. Assessments of the impact of this policy are that
it had limited effect in raising aggregate demand and prices, but provided some support to the countrys banking sector (Spiegel 2006;
Ugai 2007).
The Federal Reserve and other central banks have introduced
extremely large amounts of funds into the financial system through
quantitative easing. The sizes of their balance sheets have increased
considerably since 2007. This expansion of liquidity was confined
to the banking sector initially. It has since resulted in a corresponding improvement in the supply of credit and liquidity to the retail
non-banking sector.
Quantitative easing might also affect behaviour in financial markets in another way. Large purchases of government securities by the
central bank are likely to drive their prices to levels that reduce, if
not eliminate altogether, their attractiveness as an investment option.
Koo (2011) argues that, with the private sector deleveraging due to
balance-sheet difficulties, fund managers, devoid of both private
sector and public sector borrowers, will turn to commodities as an
alternative investment option. This effect may have been at play in
commodity price behaviour since the introduction of programmes
of quantitative easing.
It is important to remember that this is a portfolio-rebalancing
effect and may not have a lasting effect on commodity prices, given
that other asset markets should be expected to return to normality
at some time in the future. The portfolio-rebalancing effect, however, is distortionary in the short run, as investors are effectively
constrained into purchasing commodities. This cannot be beneficial
to commodity markets, and to the efficient allocation of investment
resources more generally within the economy.
The acceleration in the growth of the M2 money stock in the latter
half of 2008 while the US economy was still in recession is likely
to have helped maintain momentum to commodity prices.4 In the
next section, we discuss how a monetary shock has a proportionate
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impact on commodity prices and consumer prices in the long run,

while causing an overshooting of equilibrium commodity values in
the nearer term.
THE INFLUENCE OF COMMODITY PRICES ON FINAL GOODS
INFLATION
Developments in commodity markets routinely and directly affect
final good prices, as commodities constitute an input into the production of those goods. The impact of commodity prices, however,
is less strongly felt nowadays than, say, in the 1970s, as commodities account for a smaller share of final expenditure. This reflects the
changing structure of the economy over time, away from manufacturing and towards services. It also reflects improved production
techniques, requiring less raw material and fewer energy inputs. As
already mentioned, central banks are also now more skilled in ensuring that large commodity price increases do not become embedded in the inflationary process. Econometric assessments support
the diminished influence of commodity prices on overall final good
prices. Blanchard and Gal (2010), for example, found that the passthrough from oil price changes to overall inflation rates had declined
over time in a set of industrialised economies.
The origin of commodity price changes is debated in the economics literature. One perspective sees developments in commodity
prices arising from market-specific, supplydemand shocks. There
may, for instance, be some new or enhanced source of demand for
a commodity, a sudden disruption to supply due to weather affecting crop harvests, or political events threatening the availability of
a raw material. The commodity price changes that result are ultimately relative price changes, and may often be transitory. They
can have direct price effects on the CPI, if the commodities are
a part of the consumer basket, and indirect pass-through effects
when the commodities affected are part of the production process
of consumer goods.
Market shocks can have a rapid and sizeable effect on the prices of
the particular commodities affected. This follows from the fact that
they are traded on open markets, which helps make commodity
prices relatively flexible. Since final goods prices are less flexible,
and adjust slowly to economic developments, commodity prices
may contain useful information as to how consumer prices will
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behave in the future.5 Many older US studies of the commodity

price-consumer price relationship focused on the predictive power
of commodity prices for CPI inflation.6 The evidence presented in
these studies with regard to the predictive power of commodity
prices is mixed.
The price-flexibility attribute of commodity markets may also contribute to the view that, since market-specific shocks are short-lived,
the resulting pronounced directional changes in commodity prices
will be a temporary, and self-correcting, phenomenon. This view,
and the recognition that relative price shifts are a necessary and
valid part of economic activity, may contribute to the aforementioned monetary policy perspective that commodity price shocks
can be ignored.
An alternative viewpoint starts from the premise that the level
of prices in the economy is determined in the long run by the
money supply, and that the central bank, through its ability to control the money supply by monetary policy, has an influence on how
commodity prices and final good prices develop over time. Commodity price increases then may be seen not as originating exclusively in market-specific shocks but as arising, in part at least, from
the monetary policy stance. Insofar as commodity price developments feed through into CPI inflation rates from this source, it has
a monetary basis.
This perspective, focusing on the role of money supply, and monetary policy more generally, in driving commodity price changes, reemerged in the 2000s. Barsky and Kilian (2002), for instance, examine
the Great Stagflation of the 1970s, and produce econometric evidence
that monetary conditions explain the rise in the price of oil and other
commodities at that time. This runs counter to the more orthodox
perspective that supply shocks affected oil prices and caused both
high inflation in goods and services and lower output.
Frankel (2008) revisits an overshooting theory of commodity
prices that he first put forward some 20 years previously (Frankel
1984, 1986). This theory follows from the view that monetary policyinduced changes in interest rates affect real/inflation-adjusted interest rates because the CPI is sticky, ie, inclined to change only
slowly. Suppose that monetary policy causes a rise in the nominal
interest rate. This will also lead the real interest rate to increase, since
the CPI inflation rate is fixed in the short run. The relevance of the
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real interest rate for commodities is that it represents the opportunity cost of holding them. A rise in the real interest rate then reduces
the demand for commodities, causing their real prices to fall. In this
way, monetary policy has an impact on commodity prices through
its effect on real interest rates.
In the Frankel model, the amount by which commodity prices
decline is determined by a no-arbitrage condition. Commodity
prices must fall to the extent that their subsequent appreciation to
long-run values compensates their holders fully for the increased
cost of carrying them. Prices, then, overshoot equilibrium values
to meet this market requirement. Subsequently, the CPI inflation
rate will itself adjust (slowly) upwards, and the real interest rate
will decline, acting to restore equilibrium to the commodity market.
In his 2008 article, Frankel emphasises the relevance of his overshooting theory to developments in commodity prices around that
time. He attributes the rise in commodity prices in 20024 to declining real interest rates. A number of other studies find a similar relationship between commodity prices and real interest rates. Using
quarterly data covering the years 19902007, Akram (2009) finds
commodity prices increase significantly in response to reductions in
real interest rates. The econometric results of Anzuini et al (2010)
indicate that expansionary US monetary policy shocks increase
commodity prices, albeit to a limited extent.
In Browne and Cronin (2010), we also provide an overshooting theory of commodity prices. Whereas Frankels perspective
draws on the Dornbusch (1976) theory of exchange rate overshooting in framing his model, we use two (essentially Friedman-style)
monetarist propositions to develop ours. These are that exogenous
changes in the nominal money stock lead to equivalent percentage changes in the overall price level (comprising commodity and
consumer good prices), and that exogenous changes in-the-money
stock are neutral in the long run, implying that all individual prices,
whether they be of consumer goods or commodities, adjust over
time in the same proportion as the money stock, thus leaving all
relative prices unchanged.
When these two propositions are combined with an acknowledgement that commodity prices are more flexible than consumer prices,
commodity prices are shown to overshoot their new long-run equilibrium values in response to a change in the exogenous money
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supply, to compensate for the inability of consumer prices to adjust

in the short run. In this way, the overall price level moves at the
same rate as the money stock, but, initially, commodity prices move
more than they do in the long run to offset the stickiness of consumer
prices.
A THEORY OF OVERSHOOTING
A simple two-period model might help develop some insight, and
guide a more formal statistical approach (see also Browne and
Cronin 2010). We assume there are two exchangeable goods, commodities and the CPI basket, which together add up to the real output Y of the economy. At any time, the overall price level P will be
the weighted average (with weight w, 0 < w < 1) of the commodity price index F, which is flexible, and the consumer price index S,
whose price is sticky. For example, at time t
Pt = wFt + (1 w)St
The relationship between the money stock, M, and the overall price
level is given, at each time t, by the Fisher identity, that is
Mt Vt = Pt Yt
We assume both that the velocity of money Vt is constant and equal
to 1, and that the volumes of the two goods in our economy, and
thus the real output Yt , do not change (this restriction is relaxed in
our econometric analysis, where real GDP is one of the statistical
variables). When the assumptions about the exogeneity of Y and
the constancy of V (equal to 1) are added to the exogeneity of M
(controlled by monetary policy), the Fisher identity becomes the socalled quantity theory of money, and the overall price level Pt moves
in line with the nominal money stock Mt .
Assume all prices are in equilibrium at time t 1, and Pt1 is the
overall price level, as determined by the size of the money stock at
that time, ie, Mt1
Mt1 Vt1
Pt 1 =
Yt1
Next, suppose there is a one-off increase in-the-money stock of > 0
percentage points (of course, a similar analysis can be done for a
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negative shock)
Mt = (1 + )Mt1
Pt =
Mt Vt
Yt
The overall price level also rises by the same percentage amount,
given the proposition that it moves contemporaneously with the
size of the money stock (Vt1 = Vt = 1; Yt1 = Yt = Y). Without
other shocks, the new equilibrium overall price level PNEW EQ will
hold indefinitely into the future
Pt = (1 + )Pt1 = PNEW EQ = wFNEW EQ + (1 w)SNEW EQ
Over time, both commodity and consumer price indexes converge to
their equilibrium levels FNEW EQ and SNEW EQ , but it is what happens
in the meantime that is of most interest. In particular, we assume that
the consumer price index is sticky for one period after the money
shock, that is
St = (1 + )St1 with <
while commodity prices, which are traded on spot auction markets,
are fully flexible, and move percentage points in order to maintain
overall price equilibrium, ie
Pt = (1 +)Pt1 = wFt +(1 w)St = w(1 +)Ft1 +(1 w)(1 + )St1
or, rearranging the terms above
1 w St1
1+
1+
=1+
1
1+
w Ft1
1+
Thus, it is clear that if > 0 and < , then

>
which means that commodity prices initially overshoot equilibrium,

to compensate for the interim stickiness of consumer prices. Next,
if we assume that in period t + 1 commodity prices and consumer
prices both adjust to their new respective equilibrium levels, ie,
Ft+1 = (1 + )Ft1 = FNEW EQ
St+1 = (1 + )St1 = SNEW EQ
then, from the overall price equation that holds at all times
wFt + (1 w)St = wFt+1 + (1 w)St+1 = wFNEW EQ + (1 w)St+1
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so that
St+1 St =
w
[Ft FNEW EQ ] = [St SNEW EQ ]
1w
which tells us that the overshooting of commodity prices (or the

undershooting in consumer prices) at time t, coupled with our knowledge of reversion towards equilibrium, should help to forecast the
change in the CPI price index in period t + 1.
ECONOMETRIC FINDINGS
In Browne and Cronin (2010), we tested this intuitive formal theory
empirically as a basis for shedding light on the nature of both
short-term dynamics and long-term relationships among four US
variables:
1. the M2 money stock;
2. the Consumer Price Index (CPI);
3. the Commodity Research Bureau Spot Index (CRBSI), which
comprises 22 basic commodities;
4. real gross domestic product (GDP), which measures output in
the US economy.
These correspond to M, S, F and Y above, respectively. The sample
period covered was Q1 1959Q4 2008. (The data used in the empirical
estimations and the figures are outlined in Table 11.1.)
We initially undertook standard unit root tests on natural logs
of the four variables, which indicated that they could be treated
as integrated of order one. This property of the series allowed us
to use the Johansen cointegration technique to assess the existence
of a long-run proportional relationship between M2 and each of the
two price variables and to assess the short-run dynamic relationship
between the variables.
Our empirical results provide support for the theory (and are
summarised in Figure 11.1). In summary, we find the following.
(i) Commodity and consumer prices each move in proportion
to the money stock in the long run, although convergence is
rather slow (measured in quarters on the x-axis in Figure 11.1).
(ii) Commodity prices initially overshoot their new equilibrium
value in response to a money supply shock; the CPI is initially
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Table 11.1 Description and sources of data

CPI for all urban Index:
consumers:
19824
all items
= 100
SA
US Department of Labor:
Bureau of Labor
Statistics
CRBSI
Index:
1967 = 100
NSA
Commodity
Research Bureau
M2
US$ billion
SA
Board of Governors of the

Federal Reserve System
Real GDP
Billions of
SAAR US Department of
chained 2005
Commerce: Bureau of
US dollars
Economic Analysis
CPI, Consumer Price Index; CRBSI, Commodity Research Bureau Spot

Index; SA, seasonally adjusted; NSA, not seasonally adjusted; SAAR,
seasonally adjusted annualised rate.
Figure 11.1 Response of variables to an M2 shock

CRBSI
0.03
M2
CPI
GDP
0.02
0.01
0
0.01
8 16 24 32 40 48 56 64 72 80 88 96 104 112120 128136144

Quarters
Source: Browne and Cronin (2010).
slow to adjust, but eventually picks up after commodity prices

have peaked.
(iii) One-quarter lagged values of the deviation of the commodity price index from its equilibrium/money-determined value
have explanatory power for current-quarter CPI inflation.
(iv) The sign of the coefficient for the lagged commodity price gap
is positive, as is to be expected from the theory.
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(v) GDP receives a temporary boost from an increase in money

stock, lasting about two or three quarters, but it then reverts
to its initial value.
For this chapter, we revisited the relationship between the variables, extending the data set up to Q1 2011, and present the results in
a new way. Figure 11.2 contains two series. The first is the year-onyear rate of CPI inflation on a quarterly basis from Q1 1960 to Q1 2011,
with the Q1 1960 value reflecting the rate of inflation over the previous four quarters, ie, the percentage change in the CPI between
Q1 1959 and Q1 1960, and so forth. The second series is a measure of the commodity price gap, where the commodity index is the
CRBSI, and the gap is defined as the percentage difference between
the actual index value and our estimate of the corresponding equilibrium value, as determined by the money equation at that time. A
positive gap indicates actual commodity prices being above equilibrium. Given the discussion above, the expectation is that when the
gap is positive, the rate of CPI inflation will subsequently increase.
As a general observation, the co-movement between CPI inflation rates and the commodity price gap is noticeable. Looking at
how the two variables behaved over time, the period up until the
early 1970s was one when the commodity price gap was usually negative and CPI inflation relatively low. A large positive commodity
price gap emerged in 19734 and the CPI inflation rate responded
accordingly, moving into double-digit values. This situation prevailed through the rest of the 1970s. The CPI inflation rate declined
steadily between 1980 and 1983, as the positive commodity price
gap was also eroded. Thereafter, through the 1980s and 1990s, the
CPI inflation rate remained at low values and the commodity price
gap moved around the origin.
The 2000s proved a more interesting decade. A large negative
commodity price gap had developed by the end of 2001/early 2002.
Over the next six years, however, the gap first closed and then moved
into positive values, reaching a local high value in Q3 2008. CPI
inflation increased slowly from a rate just above 1% in Q2 2002 to a
value close to 5% in Q3 2008.
Figure 11.3 helps to illustrate how our overshooting theory can
explain these developments in the early to mid 2000s, as well as
those that have occurred since 2008. It shows year-on-year rates of
change in US M2, US CPI and the CRBSI from Q1 2001 to Q1 2011 (so,
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CPI inflation rates
Commodity price gap
40
20
0
Q3 2009
Q1 2004
Q3 1998
Q1 1993
Q3 1987
Q1 1982
Q3 1976
Q1 1971
40
Q3 1965
20
Q1 1960
Commodity price gap (pp)
60
16
14
12
10
8
6
4
2
0
2
4
CPI inflation rates (pp)
Figure 11.2 Year-on-year CPI inflation rates and commodity price gap,
Q1 1960Q1 2011 in percentage points
Figure 11.3 Year-on-year rates of change in M2 and price indexes,

Q1 2000Q1 2011, in percentage points
M2
CRBSI
CPI
Q1 2001
Q3 2001
Q1 2002
Q3 2002
Q1 2003
Q3 2003
Q1 2004
Q3 2004
Q1 2005
Q3 2005
Q1 2006
Q3 2006
Q1 2007
Q3 2007
Q1 2008
Q3 2008
Q1 2009
Q3 2009
Q1 2010
Q3 2010
Q1 2011
40
30
20
10
0
10
20
30
40
for example, the Q1 2001 observations are the year-on-year changes

in the respective variables between the end of Q1 2000 and the end
of Q1 2001). A vertical line is added at Q3 2008. Prior to that quarter,
the rate of M2 growth can be seen to have been in excess of that of
the CPI from the early 2000s. The money stock grew by 68% between
Q1 2000 and Q2 2008, while CPI increased by just 28%. The difference
could not be explained by the greater need for real money balances
for transactions purposes associated with real GDP growth, which
totalled 20% over that period. In these circumstances, it is unsurprising to us that the CRBSI rose strongly in value. It more than doubled
during this time-frame, increasing by 115% between Q1 2000 and
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Q2 2008. With the rate of change in the CPI not keeping pace with
that in M2, the monetary impulse affected commodity prices.
The differential between the M2 growth rate and the CPI inflation
rate is particularly noticeable between 2001 and 2003, as can be seen
in Figure 11.3. The rate of change in the CRBSI did not pick up until
2003 and was maintained into 2005. The overshooting theory would
explain this by noting that the response of commodity prices to a
monetary stimulus is not instantaneous, but rather occurs with a
lag; however, that lag is relatively short and the response is faster
than that of consumer prices.
There was some pick-up in the CPI inflation rate in 20045, as
the rate of commodity price inflation declined. This would be consistent with the eventual catch-up in CPI inflation rates that would
be expected in the wake of strong money growth, and in the initial
momentum to commodity prices from that monetary source falling
away. The period from early 2006 to mid 2008 saw a fresh surge in
commodity prices taking place. Money growth was also above the
CPI inflation rate at that time. As in 2005, the decline in the rate of
increase in commodity prices that was occurring just prior to Q3 2008
coincided with a steady rise in the CPI inflation rate to a value of 5%
in Q2 2008.
The vertical line at Q3 2008 in Figure 11.3 marks the start of a
sudden collapse in commodity prices in the second half of that year.
Year-on-year rates of growth in the CRBSI remained negative until
Q1 2010. Given that the rate of money growth was much greater
than the rate of the CPI inflation rate in late 2008 and through
2009 when commodity prices were, in general, falling, this commodity price behaviour may appear unusual.7 We suggest that a
flight from risky assets, such as commodities, to safe haven assets,
like money (accommodated by monetary policy), by consumers and
investors was the predominant force at work in financial markets in
late 2008/early 2009 and goes a long way towards explaining the
money and commodity price growth rates in Figure 11.3 during
that time. Since the level of uncertainty and investor nervousness
in the economy has receded somewhat since then, it is unsurprising that strong money growth manifests itself in rising commodity
prices. A positive commodity price gap is now evident (Figure 11.2).
This raises the prospect of CPI inflation rates rising in the years
ahead.
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CONCLUSION
In this chapter, we described how inflation targeting became a central plank of modern monetary policy. It contributed to a reduction in inflation rates from the high values that prevailed in the
1970s and 1980s, and did so mainly through succeeding in anchoring inflation expectations close to low levels. Inflation targetings
biggest shortcoming, in our view, is that it has not taken account
of the vast changes that have occurred in the financial system since
the 1990s. These changes have altered the patterns of substitution
between money and financial assets. In our view, these new patterns are an important ingredient of the boombust cycles of the
1990s and 2000s. They have had the effect of enhancing the role of
money in the economy, but arguably in a disruptive way: something which was at the heart of the 20079 financial crisis, but
which most advocates of inflation targeting regard as something
of a sideshow.
Our overshooting model provides some input into understanding the potential for money to affect prices, including relative prices
between different classes of goods, such as commodities and consumer goods. It shows that monetary shocks can cause commodity
prices to react quickly to maintain equilibrium in the overall price
level. This can arguably prove unsettling for investors, as rising commodity prices may be interpreted as signalling a higher sustained
level of real demand for a commodity or commodity class when,
in fact, their prices are only reacting to a generalised, ie, monetary,
stimulus to prices in the economy. Monetary policymakers, mistakenly reading rising commodity prices as caused by market-specific
demand or supply shocks, might thus adopt inappropriate monetary policy responses, including no response at all. For both investors
and central banks, money is a variable that needs to be analysed and
understood, and not neglected.
The views expressed in this chapter are those of the authors and do
not necessarily represent the views of the Central Bank of Ireland
or the European System of Central Banks. We would like to thank
the editors for their very helpful comments and suggestions.
1
Using an econometric technique called band-pass filtering, Cuddington and Jerrett (2008)
provide evidence consistent with there having been three super-cycles in metal prices since
around the middle of the 19th century, with world metal markets currently being in the
early stages of a fourth super-cycle. They note that the latter is being attributed to Chinese
urbanisation and industrialisation.
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The quantity theory of money links money supply with the overall price level.
Uncovered by the seminal work of A. W. Phillips, the original Phillips curve refers to the
inverse relationship between unemployment and money wage rates. Other versions of the
model were later introduced, linking inflation with various measures of broad economic
activity and, later, inflation expectations.
M2 is one of the aggregate monetary measures, see http://www.federalreserve.org for a

definition.
Within the CPI, there are goods whose prices are more flexible than others. Bils and Klenow
(2004) find the fresh-food, energy-related products and durable-goods components of the CPI
to change relatively frequently. In the euro area, energy and unprocessed food have the most
flexible prices among consumer goods, while services have the lowest (lvarez et al 2006).
See, for example, Webb (1988), Garner (1989), Marquis and Cunningham (1990), Cody and
Mills (1991), Pecchenino (1992), Blomberg and Harris (1995) and Furlong and Ingenito (1996).
Another factor at play here is that the massive amount of hoarding of liquid balances induced
by the crisis has undermined the assumption of constant velocity, as often happens in
recessions.
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12
Inflation and Asset Prices
John A. Tatom
Indiana State University
Changes in the general level of prices and inflation have profound

effects on asset prices. There are several reasons for these effects
and the influence differs depending on the source of the inflation
and whether it is expected or not. To understand these effects, it is
important to clarify what is meant by inflation, the pure theory of
the sources of inflation, how inflation affects the prices of goods and
services and how it affects both the equity prices and fixed income
assets that are used to finance production.
Inflation has had large effects on asset prices in the US, especially
during the Great Inflation from 1965 to 1984. There have been lesser
bouts of inflation since then, and an acceptable and stable pace of
inflation for more than a few years at a time has been elusive. The
Great Inflation was followed by the Great Moderation (see Chapter 1), a reduced volatility of real GDP growth, which some analysts
argue was caused by improvements in monetary policy in pursuing lower and more stable inflation (Bernanke 2004). Blanchard and
Simon (2001), for example, documented that the variability of quarterly growth in real output (as measured by its standard deviation)
declined by half since the mid-1980s, while the variability of quarterly inflation declined by about two thirds. Kim and Nelson (1999)
and McConnell and Prez-Quirs (2000) were among the first to note
the reduction in the volatility of output. Kim et al (2004) showed that
the reduction in the volatility of output is quite broad based, affecting many sectors and aspects of the economy. Using more formal
econometric methods, Kim et al also found that structural breaks in
the volatility and persistence of inflation occurred about the same
times as the changes in output volatility.
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In this chapter we do not explore what constitutes an acceptable

rate of inflation. The Federal Open Market Committee of the Federal Reserve System (Fed) has struggled with this question and the
related question of inflation targeting. The policy and investment
communities have consensus estimates that the Fed aims for a 2%
annual rate of inflation maintained on a year-over-year basis, but it
tolerates moves above and below this, especially when the deviation
of inflation is perceived by the Fed and the market to be temporary.
The European Central Bank targets more explicitly on inflation, aiming for a 02% inflation rate, closer to the top of the range, again on a
year-over-year basis. The reasons for tolerating a positive target rate
of inflation appear to be twofold. First, economists expect there to
be some bias in prices and inflation due to technological change that
results in measured inflation that actually reflects quality improvements. Second, there is reluctance on the part of policymakers to
experience deflation, a falling general level of prices. Given the random variation of inflation measures, targeting zero inflation could
result in frequent and sometimes persistent experiences of negative
measures of inflation.
We do, however, review the theory of inflation, its sources and
effects on asset prices, especially equity, bond and real asset prices.
The theory behind these effects is kept to the essentials and is
reduced to its simplest details. In the first section, we explore inflation, including what it is and what it is not. We develop the important
distinction between a price level and relative price change, the difference between a sustained pace of price level change and a one-time
or transitory change, and the link between inflation and monetary
policy, as well as the implications for asset prices. We also discuss
the variety of price index and inflation measures and the usefulness
of core measures of inflation. The subsequent sections look at the
role of money in the economy and the notion of money as a veil,
hiding the fundamental real activity in an economy, and establishing
the theoretical benchmark of an economy where money is neutral,
which means that inflation has no effect on real economic activity
and, in particular, on real asset prices and real returns. This concept
of neutral money is explained in more detail by Fisher (1911). It is
rumoured to have originated with Copernicus in the 15th century
and appears in the work of David Hume in the 18th century (see
also Friedman 1956; Patinkin 1965). The key alternative hypotheses
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INFLATION AND ASSET PRICES
of how inflation affects asset prices by altering real interest rates or

the required real rate of return on equity, and/or by affecting real
earnings on corporate equity, are examined and evidence is provided
supporting both. Taxation effects, often a neglected topic, are then
discussed. A final section offers concluding remarks.
WHAT IS INFLATION?
Economists and financial analysts recognise several key distinctions
when discussing inflation. The most important is that the term refers
to a sustained rate of depreciation of the purchasing power of a unit
of local currency over time. A rise in the price of a kilo of beef from
$10 per kilo to $11 per kilo reflects the fact that a unit of money buys
less than it did before: after the price rise, $10 buys only 0.91 kilos of
meat instead of one kilo.
If only the beef price rises, then this is referred to as a relative price
change: beef has become more expensive relative to everything else,
including money. A rise in the relative price of one good or another
is not inflation if the overall price level (for example, of a relevant
basket of goods and services) is unchanged. However, if all prices
move in line with beef prices, then the price of a market basket of
goods and services rises by 10%, or the value of money falls by
roughly 10% (9.1%). Measured on a continuously compounded rate
basis (differences in the natural logarithms), prices rise 9.53% and
the value of money relative to goods and services falls by exactly
the same extent (9.53%). If the general level of prices, beef and other
goods and services, rises for some special reason that is not expected
to continue, this is referred to as a rise in the price level, or sometimes
as temporary inflation, but not inflation.
Inflation is a monetary phenomenon
Friedman (1956) famously coined the expression inflation is always
and everywhere a monetary phenomenon. This captures the fact
that the principal cause of inflation is the excess of growth in-themoney stock relative to that of money demand. Like other goods
or services, an increase in the price of money (relative to goods and
services) depends on its relative scarcity, so growth in supply relative
to demand causes decreases in the value of money or inflation.
With fiat money under the control of central banks, the supply of
money is determined by actions of the central bank and by changes
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in preferences for currency or deposits. Since the central bank can

readily detect shifts in these preferences and offset their influence on
monetary measures, changes in the stock of money are fully under
the control of the central bank. The demand for money depends on
the cost of holding money and its usefulness in facilitating transactions or providing liquidity in asset portfolios. The cost of holding a
given amount of money is the short-term nominal interest rate, typically measured by the most liquid safe domestic security like the
US Treasury bill rate in the US. This captures the alternative return
from holding a very liquid and safe asset (a Treasury bill) instead of
currency or a bank deposit that can be used for third-party payment
or readily and cheaply converted into such a transaction deposit.
Alternatively, the nominal interest rate reflects the real interest rate
forgone by holding money and the rate of depreciation expected
on holding money, ie, the expected rate of inflation. The transaction
demand for money depends on income, real GDP and measures such
as the size of wealth relative to income, alternative rates of return on
alternative assets and the liquidity of wealth and the degree of uncertainty can influence the demand for money. See Friedman (1956)
for the classic statement of the demand for money and its link to
inflation.
Non-monetary factors
There are other factors that can account for temporary inflation or
price level increases. In particular, as described above, the general
level of prices can be raised by a decline in money demand. A principal source of such a decline is a negative shock to aggregate supply of
actual and potential output. This can occur because of a reduction in
available resources or a reduction in total factor productivity. Rasche
and Tatom (1977) developed the aggregate supply theory, which
explains the loss in natural output and price level rise associated with
a shock to the relative price of energy. In a broader study of energy
and other supply shocks (Rasche and Tatom 1981), they developed
the theory of energy shocks more fully. Examples of energy shocks
are plagues, wars, strikes or a decline in resource use because of
shock to the relative price of a key resource such as an energy price
shock. An example of a supply shock is a crop failure or other natural disaster that significantly reduces output, given resource usage.
Supply shocks can be permanent or transitory. When permanent,
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they can lead to a permanent rise in the price level, experienced as

temporary inflation. The most important empirical example of this
is a rise in the relative price of oil that raises the relative price of
energy. When transitory, the relative price of the affected good or
service rises temporarily and then returns to its original level after
the source of the shock is removed. The price level reflects the same
transitory rise and fall in this case. The best empirical example of this
is a crop failure, drought or other natural disaster that temporarily
reduces output in a key sector of the economy. Conceptually, a permanent continuing shock to supply could be a source of a sustained
rise in the relative price of a resource and therefore inflation, but this
requires an ongoing reduction in the employment of some resource
that reflects or causes the reduction in economic growth.
While such non-monetary factors might suggest that Friedman
is wrong in his argument that inflation is always and everywhere
a monetary phenomenon, this is not the case. In fact, the simplest
version of Friedmans explanation of inflation is that it occurs when
more money chases the same goods; but, these non-monetary explanations rely on the same quantity of money chasing fewer goods. In
both cases, inflation occurs because there is a change in the quantity
of money relative to potential output.
Measures of inflation
There are several measures of inflation. The broadest measures are
the chain weight GDP deflator, which measures changes in the price
index for the bundle of final goods and services that make up the
nations output, or real GDP. Since consumer expenditures make
up the largest share of GDP and are the prices most relevant to consumers, analysts often focus on the chain weight personal consumption expenditure (PCE) deflator as the benchmark for assessing inflation. Many analysts focus on the consumer price index (CPI) as the
relevant measure of inflation. This measure has a history of problems. Most importantly, the housing component of the index was
revised in the 1990s to better measure the price of housing, but the
earlier series was not revised in the same way, making the index less
reliable for longer-term studies. Figure 12.1 shows the year-overyear measure of the rate of increase in the PCE deflator, the PCE
minus energy and food (a so-called core inflation measure) and the
CPI. All three measures are broadly similar, though the CPI-based
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Figure 12.1 Personal consumption expenditure, core personal

consumption expenditure and consumer price index
16
14
12
10
8
% 6
4
2
0
2
PCE
Core PCE
CPI
2009 Q1
2005 Q3
2002 Q1
1998 Q3
1995 Q1
1991 Q3
1988 Q1
1984 Q3
1980 Q1
1977 Q3
1974 Q1
1970 Q3
1967 Q1
1963 Q3
1960 Q1
Source: FRED2, Federal Reserve Bank of St Louis.
measure is slightly higher and more volatile. The Great Inflation in

196584 stands out, but there are other episodes of relatively high
inflation.
Since there are some prices that are very volatile but do not reflect
the underlying trend in the value of money or of the general level of
prices, statisticians and analysts often distinguish a core measure
of inflation from the overall measure. The measurement of core inflation uses price indexes that remove the price movements in non-core
items: most often the prices of food and energy, but sometimes housing rent or other volatile prices. The reasons for excluding items from
an inflation measure are that the volatile changes are not expected
to persist and indeed, at least in the case of food prices, they are
expected to cancel out over time, except for some trend decline in
the relative price of food. In any case, the sustained rate of price
change, that is inflation, is likely to be obscured by noisy volatile
movements in some price components within the overall index of
the general level of prices. This may not always be correct, however (especially the presumption that volatile moves up or down
in a particular nominal price is likely to be reversed) so care must
be exercised in the choice of inflation measure. Crone et al (2011)
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provided evidence that overall PCE deflator inflation is a better predictor of its own future rate than is a core measure. Kiley (2008)
reached the opposite conclusion about how to estimate the underlying trend of inflation. Mankiw et al (2003) provided an earlier survey
on the issues involved in developing inflationary expectations; they
suggest that expectations reflect partial and incomplete updating in
response to news. In Figure 12.1, temporary surges in inflation in
19745, 197981, 1991, 2000 and 20089 reflect sharp increases in the
relative price of energy. The end of the IranIraq war in 1986 and the
IraqKuwait war in 2001 led to declines in the relative price of oil
and energy that were reflected in declines in prices and temporary
drops in inflation.
An important issue that is not explored here is how and whether
asset prices should be included in measures of the price level.
Alchian and Klein (1973) stressed the importance of including assets
in the market basket of expenditures along with goods and services. Others have argued for including the prices of the services of
assets, but not the assets themselves, along with other goods and services. For example, house prices would be excluded, but the owners
equivalent rent or other rental prices of housing would be included.
Stock and Watson (2003) examined evidence on the predictive performance of asset prices for inflation and real output growth, using
data from 38 asset price indicators (mainly asset prices) for seven
member countries of the Organisation for Economic Co-operation
and Development (OECD) for the period 195999. Their review of
the literature and empirical evidence points to the same conclusion,
ie, that some asset prices predict either inflation or output growth in
some countries in some periods. However, no systematic evidence is
found to support the inclusion of asset prices in standard price measures. Bryan et al (2002) found that including asset prices in models
to forecast inflation does have episodic significance in altering the
pattern of inflation forecasts, but that they do not matter much for
economic significance beyond the quality of forecasts from either
overall inflation measures or from core measures of inflation.
A third critical distinction is that inflation can be expected or unexpected. A surprise in inflation will have different effects on asset
prices and economic performance from a rise in expected inflation
that is in line with ex ante expectations. Most surprises in inflation arise from shifts in relative prices, especially food or energy
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prices, and are temporary. More fundamental determinants of inflation evolve more predictably, and hence the underlying inflation
is also more predictable or expected. The key factor differentiating
expected and unexpected inflation, in terms of the effects on asset
prices, is that capital markets incorporate expected inflation in asset
demand and supply and in pricing of assets, while unexpected inflation is not incorporated in the same way. The key effects of unexpected inflation arise from redistributions of income and wealth. For
example, an unexpected and temporary rise in inflation will redistribute income from creditors, who face an unexpected fall in the
purchasing power of their interest income and principal repayments,
that is, a fall in their realised real rate of return, while debtors enjoy
their corresponding unexpected gain. For owners of firms, there are
at least two effects of unexpected inflation. The first is the redistribution of income from creditors to debtors, as above. Firms that
have external debt will benefit from a rise in unanticipated inflation.
Their owners, stockholders, will realise the unexpected decline in
their real interest payments to their creditors as a gain in real profits.
The discounted value of the gain will accrue to stockholders as an
unanticipated capital gain in the stock price.
Expected inflation usually does not create redistributions of
income or wealth. Market participants require compensation for
expected changes in the purchasing power of expected future payments in order to acquire assets, and sellers of assets have the wherewithal and willingness to provide such compensation, at least in a
simple world where institutions or regulations do not prevent such
compensation. More broadly, it is expected inflation that has more
sweeping effects on asset and other prices and that affects portfolio
allocation, output and economic growth.
IS MONEY A VEIL? THE MONEY NEUTRALITY HYPOTHESIS
The simplest model of inflation and asset prices assumes that there
are no frictions in markets, there are no transaction or adjustment
costs and that information is freely available. In this model, a rise
in expected inflation raises nominal prices for unchanged quantities of goods and services along new and higher expected inflation
paths. It simultaneously raises prices of resources and marginal costs
by equal percentages, at given quantities of goods and services and
resource input flows. Prices move up freely at the specified rates over
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Figure 12.2 Inflation and nominal interest rates

16
10Y Treasury yield
14
Inflation (PCE, YoY)
12
10
8
% 6
4
2
0
2009 Q2
2005 Q4
2002 Q2
1998 Q4
1995 Q2
1991 Q4
1988 Q2
1984 Q4
1981 Q2
1977 Q4
1974 Q2
1970 Q4
1967 Q2
1963 Q4
1960 Q2
1956 Q4
1953 Q2
time, with no distortion of resource employment or output. Relative

prices of resources, goods and services and assets are unaffected,
as are real (ie, inflation-adjusted) rates of return on assets. The use
of money is a veil, hiding the relative prices of goods, services and
assets, the real rate of interest and real exchange rates for currencies. It is these latter prices that matter for economic decisions, and
if inflation does not alter them, then it does not affect economic performance. In other words, where money is a veil, money is neutral,
so that nominal price level changes have no real effects on resource
allocation or incentives to accumulate resources. Inflation has purely
nominal effects on asset prices.
Although the money neutrality hypothesis is a long-term relationship that might not hold in the short and intermediate run, it
provides a useful heuristic model to understand money, inflation
and asset prices.
NOMINAL INTEREST RATES AND INFLATION
Existing nominal fixed income products are affected, however, when
the expected rate of inflation increases. This occurs because the rate
of depreciation in the purchasing power of future nominal cashflows has increased. Following the Fisher equation, named after Irving Fisher (1911, Chapter IV; 1907, Chapters V and XIV), the nominal
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interest rate on fixed income securities will rise in line (ie, one to one)
with the expected rate of inflation, while real interest rates and supply and demand for credit will remain unchanged. The relationship
between nominal rates and inflation is clearly shown in Figure 12.2,
where the year-over-year (YoY) PCE inflation is plotted along with
the 10-year Treasury yield.
A rise in expected inflation will cause bond prices to fall, as nominal interest rates rise to incorporate the Fisher effect of inflation on
nominal interest rates. The fall in bond prices is larger, the longer the
duration of the asset, because longer duration cashflows lose more
purchasing power due to a given pace of inflation. The real interest
rate on bonds is unaffected if money growth is neutral.
EXCHANGE RATES AND INFLATION
In this simple model, another key nominal price besides nominal
interest rates is the foreign exchange rate. The benchmark for foreign
exchange in the simple world is determined by relative purchasing
power parity, so that the value of a currency will fall over time relative to another currency, in line with the higher domestic expected
rate of inflation compared with expected inflation abroad. The rate
of depreciation in a local currency will equal the expected inflation
rate in the economy minus the expected inflation rate in the country of origin of the other currency. So long as this holds, the local
currency prices of domestic and foreign goods or services will rise
at the new expected rate of domestic inflation, and the same will be
true abroad.
Even in this simple world, currencies will not adjust fully and
immediately to a change in the expected inflation rate. In fact, currencies typically overshoot in response to factors booting inflation
expectations, falling more than the theory predicts based only on
expected future inflation. This is not unique to exchange rates, as
other asset prices also adjust more in the short run than higher inflation might suggest. The elasticity of supply of some commodities, for
example, is quite inelastic, so that increases in nominal demand lead
to relatively higher relative prices. These relatively large short-run
price adjustments can make commodities an attractive investment
option in the short run. Balanced against this argument, however,
is the short-term nature of these adjustments. Many commodities
are also very sensitive to the business cycle and relatively more
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Real S&P index
Inflation (PCE, YoY)
14
12
6
4
Inflation
10
8
2
2
2009 Q3
2011 Q2
2006 Q1
2002 Q3
1999 Q1
1995 Q3
1992 Q1
1988 Q3
1985 Q1
1981 Q3
1978 Q1
1974 Q3
1971 Q1
1967 Q3
1964 Q1
0
1960 Q3
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
1957 Q1
S&P index
Figure 12.3 Inflation (PCE) and real stock prices (inflation-adjusted

S&P 500 index)
Source: FRED2, Federal Reserve Bank of St Louis and Standard & Poors.
cyclical industrial demand, which also is more adversely affected by

any subsequent policy tightening in the face of a rise in inflationary
expectations.
EQUITY PRICES AND INFLATION
According to the money neutrality hypothesis, the required return
on equities also moves in line (ie, one to one) with the higher expected
inflation rate. According to cashflow valuation models, the price of
a stock is the net present value of future cashflows. If expectations of
inflation rise, but real cashflows and real interest rates do not change,
the price of stocks and their real rate of return should be unchanged
as well. In this case, equities would be a perfect inflation hedge,
providing a constant real rate of return independently of changes in
inflation expectations.
In practice, however, there is strong empirical evidence that
changes in inflation expectations are negatively correlated to the
real (inflation-adjusted) return on stocks. In other words, equities are
not a good inflation hedge. Figure 12.3 provides a perspective on the
negative effect of inflation on real (inflation-adjusted) equity prices.
It shows the real (deflated by the PCE deflator) S&P 500 index, and
the PCE-based inflation rate for the period from 1957 Q1 to 2011 Q2.
The negative correlation is most apparent during the Great Inflation,
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196584, when the real stock was depressed. Other periods of relatively higher inflation are also associated with relatively low real
stock prices, including the late 1950s and 20079. The decline in inflation in 19918 was notably associated with a sharp rise in the real
stock price. The correlation between the two series is 0.44: strongly
negative.
In fact, the negative correlation between inflation and nominal (or real) stock prices has become one of the most commonly
accepted empirical facts, motivating large numbers of financial and
monetary economics studies. Some of these are briefly mentioned
below, starting with an exception: one study that disagrees with the
empirical finding of the negative relationship between inflation and
stock prices. Konchitchki (2011) suggests that inflation raises both
future real earnings and real stock prices. He provides evidence that
unrecognised accounting inflation gains raise future cashflows, and
yield abnormally high returns on equities, reflecting a failure of the
market to fully account for future gains in nominal cashflow when
inflation initially occurs.
The most widely accepted hypothesis of a negative effect of inflation on stock prices is that supply shocks, which reduce output and
raise prices, also reduce the marginal productivity of capital, reducing the real earnings of capital and lowering the value of capital
assets and the firm.
Bakshi and Chen (1996) suggested that the negative relation of
inflation and stock prices occurs because of procyclical movements
in real interest rates and in inflation. A cyclical expansion (decline),
in their view, will raise the real rate of interest and also raise inflation. The higher real interest rate would lower stock prices, giving
rise to the negative correlation of stock prices and inflation. However, the empirical support is rather weak, not surprisingly, because
it depends on controversial empirical assertions of cyclical real interest rates and the existence of a Phillips (1958) curve. Fama (1981) and
Stulz (1986) relied on another channel: a rise in expected inflation
reduces wealth and this, in turn, lowers the expected return on equities and lowers stock prices. Fama (1981) also attributed the negative
relationship to supply shocks, again operating via a wealth effect.
Brandt and Wang (2003) provided an alternative explanation of
the negative relationship of nominal stock prices and unexpected
inflation. They argued that unexpected inflation affects investor risk
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preferences, in particular, raising risk aversion and that, in turn,

lowers stock prices.
Hess and Lee (1999) argued that the negative correlation of stock
prices and inflation depends on the nature of the shocks creating
inflation. Their theoretical structure also does not allow inflation to
have long-run real effects on output (and, therefore, stock prices).
In their view, only adverse supply shocks reduce output and stock
prices, with the former causing a temporary surge in inflation. Both
their model and evidence apply to unanticipated price and temporary inflation changes. Some studies indicate that inflation reduces
economic growth, which should slow the expected growth rate of
earnings and lower stock prices (see, for example, Barro 1996).
However, Tatom (2002) showed that both energy price (supply)
shocks and demand-induced inflation have essentially the same negative effects on stock prices, and that stock prices anticipate the
expected change in inflation from either. In each case, a 1.0 percentage point rise in inflation raises the Standard & Poors (S&P)
earningsprice yield by 1.5 percentage points, essentially all captured in a decline in stock prices, since a trailing measure of earnings
is used to construct the earningsprice variable. Tatom (2002) also
found that the temporal causality from an increase in the federal
funds rate goes to increase stock prices first, and then to decrease
inflation. Conversely, a fall in the federal funds rate will lead to a fall
in stock prices anticipating a decline in inflation.
As most of these studies, albeit important, do not take into account
nominal taxation effects, the latter are the focus of the next section.
THE EFFECTS OF TAXATION OF NOMINAL AND REAL INCOME

There are theoretical considerations that argue against neutral effects
of inflation on asset prices. Moreover, the evidence is consistent with
these theories. There are two tax-related arguments that indicate
that bond and equity prices are reduced because of an increase in
expected inflation. Income taxation systems tax nominal incomes. If
the tax system is not indexed to adjust nominal incomes measures
for inflation, taxes are levied on inflationary changes in income so
that real incomes are taxed as well. In that event, real asset prices
will be depressed by a rise in expected inflation.
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Tax rate effects on the real rate of interest

The first real effect arises through a rise in the real rate of interest.
The Fisher equation indicates that the nominal interest rate equals
the real interest rate plus the expected rate of inflation. According
to the discussion above, a rise in the expected rate of inflation, ,
will raise the nominal interest rate, n, by an equal amount, leaving
the real interest rate, r, unaffected. When nominal interest income is
taxed at a percentage rate t > 0, the after-tax nominal interest rate,
nafter tax , is
nafter tax = (1 t)n
while the after tax real interest rate rafter tax is
rafter tax = nafter tax = (1 t)r t
Therefore, the money neutrality hypothesis will not hold in a world,
like ours, where nominal income is taxed. The real rate should be
independent of inflation if money is neutral, but the results here
show that it is not. In particular, an increase in inflation expectations
should be offset by a decrease in real rates, or explicitly
dr =
t
1t
d ,
dn = dr + d =
t
1t
For example, for a marginal tax rate of one-third (t = 13 ), each

percentage point of change in expected inflation increases the real
interest rate by 50 basis points (bp), and thus raises the nominal
interest rate by 150bp. With such a rise in the real cost of funds,
producers will reduce investment in real assets, perhaps putting
some downward pressure on the after-tax real return on investment.
When the real rate of discount rises, bond prices will fall further than
otherwise, and equity prices will not keep pace with inflation as real
equity prices fall.
The empirical evidence is at odds with this result. For example,
in Figure 12.2 movements in the inflation rate are not exceeded or
even matched by movements in nominal interest rates. This suggests
that the real interest rate actually falls when inflation increases, contrary to the tax argument above. In a traditional IS/LM (investment
and savings/liquidity and money) model, ignoring taxes, there is
another factor that affects the short-run adjustment of the real interest rate to a change in expected inflation. A rise in expected inflation
rate will reduce the demand for money as investors shift to bonds
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or equities, leading to a reduction in the real interest rate and an

expansion of aggregate demand (of goods and services), real economic output and prices. The interest rate effect here is temporary
and comparable to a liquidity effect of a monetary expansion. There
is little evidence for the US that there is a liquidity effect, however.
The rise in prices has been referred to as the Friedman surge in
prices, an overshooting of the price level that will eventually go away
in the long run. The simple evidence in Figure 12.2 is consistent with
this effect dominating the tax effect above.
Tax effects on real earnings
The tax argument above also applies to equity returns. The evidence
of a negative correlation between equity prices and inflation is consistent with such a tax effect, though the evidence for real yields on
bonds is not.
Indeed, there is a second tax and inflation-related effect on equity
prices that reinforces the tax effect just discussed: nominal income
taxation does not adjust depreciation allowances or inventory valuation for inflation. Thus, inflation-related increases in inventory value
are treated as income and taxed, even though there has been no gain
in real (inflation-adjusted) terms. Similarly, depreciation allowances
do not adjust for the higher replacement cost of depreciating assets,
so that the depreciation cost of capital is understated by an increasing amount over time in an inflationary environment. The higher
the inflation rate and the longer-lived an asset, the greater the understatement of cost and overstatement of taxable income and tax. Thus,
real after-tax income from capital assets is depressed when inflation
rises.
Feldstein (1981) and Tatom and Turley (1978) are examples of
models in which inflation raises the real tax burden (due principally to accounting of inventory valuation and assets depreciation)
and lowers real after tax earnings and rates of return to capital. Fama
and French (1989) provide an explanation of how monetary policy
affects stock returns by affecting economic performance, but it is
not dependent on tax effects or supply shocks. Nominal income taxation, historical cost-based accounting of inventory valuation and
asset depreciation imply that inflation affects real earnings and the
tax burden.
Inflation raises the replacement cost of inventory and assets, but
accounting values do not reflect this. As a result, when all other costs
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2010 Q1
2005 Q3
2001 Q1
1996 Q3
1992 Q1
1987 Q3
1983 Q1
1978 Q3
1974 Q1
1969 Q3
1965 Q1
1960 Q3
1956 Q1
Economic profit
Measured profit
1951 Q3
12
11
10
9
8
7
6
5
4
3
2
1947 Q1
Percent of national income
Figure 12.4 Measured versus economic profits
and revenue keep pace with inflation, accounting depreciation and

inventory costs do not, so costs are understated, and income taxes
are overstated. As a result, true economic income is depressed, as
are stock prices that are the present discounted value of after-tax
economic income, even if the real cost of capital used to discount
future real incomes is unchanged. Interestingly, indirect support for
the hypothesis can be found in Piazzesi and Schneider (2008), who
showed that the Great Inflation led to a portfolio shift by making
housing more attractive than equity. This may reflect that depreciation rules affect corporate income, but not the market value of
owner-occupied housing.
Evidence for this hypothesis can be found by examining real
(inflation-adjusted) after-tax corporate profits (measured profits
in the following, as their non-inflation-adjusted version is the base
used to compute income taxes) and real (inflation-adjusted) aftertax profit adjusted for capital consumption and inventory valuation adjustments (true economic profits in the following). Both
numbers are reported quarterly by the Bureau of Economic Analysis (BEA, US Department of Commerce). Figure 12.4 shows the BEA
measures of after-tax corporate profits and after-tax corporate profits including capital consumption and inventory valuation adjustments, both as a percentage of national income. In this figure, each
nominal measure is shown as a percent of national income, but the
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percentages shown are identical to shares of real national income if

the same price deflator is used. During the period of the Great Inflation, measured profits exceeded economic profits by relatively large
amounts. Measured profits were also relatively high compared with
economic profit in 194751, when inflation was also relatively high
and depreciation rules were more punitive to longer-term assets.
The 1981 Economic Recovery Tax Act was aimed at reducing the
excessive depreciation on capital assets, especially long-term assets
such as structures, which were most heavily affected by inflation.
Note that after 1981 economic profit fell relative to measured profit.
It is interesting to examine the results of regressing the difference
between inflation-adjusted after-tax economic profits (EP) and comparable measured profits (MP) after natural logarithms are taken (ie,
(ln EPt /Dt ln MPt /Dt = Yt )) to changes in inflation (t ). Again,
Y is the logarithm of the ratio of real EP to real MP. The dependent
variable is the percentage excess of economic profit over measured
profit, measured on a continuous basis. As other factors influence
this ratio, especially the business cycle, the natural logarithm of the
capacity utilisation rate, CUt , is also included to capture such an
effect. A lagged value of both the profit ratio, Yt1 , and capacity utilisation rate variables, CUt1 , are also included. Using quarterly data
over the period from 1972 Q2 to 2011 Q2, the following regression
results are obtained (the t-statistics in parentheses consistently reject
the null hypothesis of zero regression coefficients)
Yt = 0.651 0.018 t 0.074 CUt 0.149 CUt1 + 0.97 Yt1
(2.23)
(7.11)
adjusted R = 0.93,
(3.20)
(2.23)
SE = 0.051,
(43.97 )
DW = 2.07
The standard error (SE) of the estimate and the DurbinWatson (DW)
statistic are both satisfactory. A one-percentage point rise in inflation
reduces economic profits relative to measured profits by 1.8%, as we
would expect. However, a rise in the capacity utilisation rate (our
business-cycle variable) also acts in the same direction, reducing
economic profit relative to measured profits: a less intuitive result,
which will be explained in the following.
The results from this regression support the hypothesis that inflation reduces the difference between economic and measured profits,
but it does not reveal how inflation affects each individual measure
individually. To this end, consider two separate regressions, one linking after-tax economic profits to inflation and the business cycle and
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the other a comparable regression for after-tax measured profits.

In both cases, the natural logarithm of inflation-adjusted (using the
PCE deflator Dt ) profits will be used, with the natural logarithm of
the capacity utilisation rate CUt included as a proxy for businesscycle effects. After searching for lags in variables (from 1 to 4, and
retaining only the statistically significant ones), the regression for
real (inflation-adjusted) after-tax economic profits is (t-statistics in
parentheses)
ln(EPt /Dt )
= 0.011 0.007 t1 + 0.796CUt
EPt1 /Dt1
(2.19)
(2.33)
(2.92)
adjusted R2 = 0.07,
SE = 0.062,
DW = 1.88
While the adjusted R2 is quite low, the independent variables are

significant as a group and individually. Lagged inflation changes
t1 have a significant and negative effect on economic profit, with
a 1% rise in inflation associated with a 0.7% loss in inflation-adjusted
after-tax economic profit. As expected, cyclical improvements in the
manufacturing capacity utilisation rate are associated with higher
economic profit, a result in line with intuition. This supports the
hypothesis that inflation lowers inflation-adjusted after-tax profits,
which are discounted (using real rates) by the market, and determine
stock prices.
For measured profits, the hypothesis is that inflation artificially
raises the tax burden. The comparable equation for the logarithm of
inflation-adjusted after-tax measured corporate profits is (t-statistics
in parenthesis)
ln(MPt /Dt )
= 0.011 0.022t1 + 1.382CUt
MPt1 /Dt1
(2.03)
(6.17)
(4.41)
adjusted R2 = 0.31,
SE = 0.070,
DW = 2.30
A one-percentage rise in inflation increases inflation-adjusted

after-tax measured profit by 2.2%. This also supports the tax effect
hypothesis and the popular view that inflation boosts measured
profits, despite the fact that the true economic effect is negative,
as seen in the previous regression. A rise in the capacity utilisation
rate is associated with a 1.38% rise in inflation-adjusted after-tax
measured corporate profit.
Finally, the interaction of inflation and accounting rules can also
be seen by looking at net (ie, adjusted for depreciation) investment
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Figure 12.5 Long-term (structures) versus short-term (equipment)

investments
1.0
50
0.5
40
Growth rate (%)
60
2005
1.5
1999
2.0
70
1993
80
1984
2.5
1978
3.0
90
1972
3.5
100
1966
110
1960
4.0
1954
120
1948
Equipment vs structures
(%, 2005 = 100)
Growth rate of structures

Non-residential equipment relative to
structures net capital stock
Source: BEA, US of Department of Commerce.
in long-term assets (mainly physical structures, more sensitive to

depreciation effects) versus short-term investment, such as equipment and software. It is evident from Figure 12.5 that investment in
long-term structures has a decisive dip during the Great Inflation of
the 1970s.
CONCLUSIONS
Inflation is a monetary phenomenon. A more rapid and sustained
pace of growth in the stock of money is the principal source of a
higher and sustained pace of general price increase or inflation.
There are non-monetary sources of temporary inflation, such as
large relative price changes associated with supply shocks, historically often caused by energy price shocks that can boost inflation
temporarily.
Expected inflation tends to raise nominal interest rates and reduce
bond prices. If the money-neutrality hypothesis holds, real interest
rates and real rates of return should be unaffected by inflation. However, even in this case, supply shocks that reduce productivity and
real income, including the productivity of real capital, reduce real
rates of return on equity and bonds. Monetary growth and inflation are not neutral, even when expected. For a variety of reasons
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reviewed here, inflation tends to raise investors required real rate

of return on equity and to lower real capital income for tax-related
reasons. As a result, there is a strong negative correlation between
inflation and real and nominal stock prices. The latter effect can be
compounded by an expected policy reaction to slow future inflation and dampen inflation expectations, but with the potential to
temporarily reduce economic activity.
Contrary to popular opinion, equities are not a good hedge
against inflation. Some alternative investments may be better, such
as owner-occupied housing, land or other non-corporate investments that are not as affected by tax rules on depreciation and
inventory accounting. In this regard, Case and Wachter (see Chapter 4) analyse the performance of several asset classes, including real
estate, in several inflation scenarios. As for corporate investments,
sectors or firms with fewer capital assets, especially long-term assets,
should provide better inflation hedges.
Tax effects are most negative for equities of firms that own longduration assets and for firms that supply such long-lived assets.
Temporary inflation associated with supply shocks also has differential effects across industries, affecting relative prices, output
and employment more heavily in industries that use the affected
resources. Not surprisingly, oil price shocks have larger effects on
industries using energy more intensively, as well as their customers
and suppliers. Indexing the tax system to account for inflation tends
to weaken many of the effects highlighted here, especially indexing
the cost basis for depreciation and inventory accounting.
Finally, increasing information on economic policy could provide
more stability and accuracy to expectations and alleviate some of
the redistributive effects that can accompany shifts in the inflation
rate. Policy-related considerations, however, are beyond the scope
of this chapter.
REFERENCES
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Credit, and Banking 5(1), pp. 17391.
Bakshi, G. S., and Z. Chen, 1996, Inflation, Asset Prices, and the Term Structure of Interest
Rates in Monetary Economies, Review of Financial Studies 9, pp. 24176.
Barro, R. J., 1996, Inflation and Growth, Federal Reserve Bank of St Louis Review 48(3),
pp. 15369.
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Bernanke, B. S., 2004, The Great Moderation, Speech to Eastern Economics Association, February 20, URL: http://www.federalreserve.gov/boarddocs/speeches/2004/
20040220/default.htm.
Blanchard, O., and J. Simon, 2001, The Long and Large Decline in US Output Volatility,
Brookings Papers on Economic Activity 1, pp. 13564.
Bordo, M. D., and D. C. Wheelock, 2007, Stock Market Booms and Monetary Policy in
the Twentieth Century, Federal Reserve Bank of St Louis Review 89(2), pp. 91122.
Brandt, M. W., and K. Q. Wang, 2003, Time Varying Risk Aversion and Unexpected
Inflation, Journal of Monetary Economics 50, pp. 145798.
Bryan, M. F., S. G. Cecchetti, and R. OSullivan, 2002, Asset Prices in the Measurement
of Inflation, NBER Working Paper 8700.
Crone, T., N. Neil, K. Khettry, L. Mester and J. Novak, 2011, Core Measures of Inflation as
Predictors of Total Inflation, Federal Reserve Bank of Philadelphia Working Paper 11-24.
Fama, E. F., 1981, Stock Returns, Real Activity, Inflation, and Money, American Economic
Review 71, pp. 54565.
Fama, E. F., and K. R. French, 1989, Stock Returns, Expected Returns, and Real Activity,
Journal of Financial Economics 45, pp. 10891108.
Feldstein, M., 1981, Inflation and the Stock Market, American Economic Review, September, pp. 83947.
Fisher, I., 1907, The Rate of Interest (New York: Macmillan).
Fisher, I., 1911, The Purchasing Power of Money (New York: Macmillan).
Friedman, M., 1956, The Quantity Theory of Money: A Restatement, in M. Friedman
(ed), Studies in the Quantity Theory of Money, pp. 321 (University of Chicago Press).
Hess, P. J., and B.-S. Lee, 1999, Stock Returns and Inflation with Supply and Demand
Disturbances, Review of Financial Studies 12(5), pp. 120318.
Kiley, M. T., 2008, Estimating the Common Trend Rate of Inflation for Consumer Prices
and Consumer Prices excluding Food and Energy Prices, Board of Governors of the
Federal Reserve System Finance and Economic Discussion Series 2008-38, August.
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Approach Based on a Markov-Switching Model of the Business Cycle, Review of Economics
and Statistics 81, pp. 60816.
Kim, C.-J., C. Nelson and J. Piger, 2004, The Less Volatile US Economy: A Bayesian Investigation of Timing, Breadth, and Potential Explanations, Journal of Business and Economic
Statistics 22(1), pp. 8093.
Konchitchki, Y., 2011, Inflation and Nominal Financial Reporting: Implications for
Performance and Stock Prices, The Accounting Review 86(3), pp. 104585.
Mankiw, N. G., R. Reis and J. Wolfers, 2003, Disagreements about Inflation Expectations, in NBER Macroeconomics Annual, pp. 20970 (Boston, MA: MIT Press).
McConnell, M., and G. Prez-Quirs, 2000, Output Fluctuations in the United States:
What Has Changed since the Early 1980s?, American Economic Review 90, pp. 146476.
Patinkin, D., 1965, Money, Interest and Prices: An Integration of Monetary and Value Theory,
Second Edition (New York: Harper and Row).
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Piazzesi, M., and M. Schneider, 2008, Inflation and the Price of Real Assets, Stanford
University Working Paper, April.
Rasche, R. H., and J. A. Tatom, 1977, The Effect of the New Energy Regime on Economic
Capacity, Production, and Prices, Federal Reserve Bank of St Louis Review, May.
Rasche, R. H., and J. A. Tatom, 1981, Energy Price Shocks, Aggregate Supply and Monetary Policy: The Theory and International Evidence, in K. Brunner and A. H. Meltzer
(eds), Supply Shocks, Incentives and National Wealth, Carnegie-Rochester Conference Series
on Public Policy 14, pp. 993.
Rich, R. W., and C. Steindel, 2007, A Comparison of Measures of Core Inflation, Federal
Reserve Bank of New York Economic Policy Review 13(3), pp. 1938.
Stock, J. H., and M. W. Watson, 2003, Forecasting Output and Inflation: The Role of Asset
Prices, Journal of Economic Literature 41(3), pp. 788829.
Stulz, R. M., 1986, Asset Pricing and Expected Inflation, The Journal of Finance 41(1),
pp. 20923.
Tatom, J. A., 2002, Stock Prices, Inflation and Monetary Policy, Business Economics,
October, pp. 719.
Tatom, J. A., and J. E. Turley, 1978, Inflation and Taxes: Disincentives for Capital Formation, Federal Reserve Bank of St Louis Review, January. Reprinted in Federal Reserve Readings
on Inflation, Federal Reserve Bank of New York, February 1979, pp. 16773.
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13
Inflation and Equity Returns
Jeffrey Oxman
University of St Thomas
Inflation is a ubiquitous feature of the modern industrial economy,

and therefore we all need to protect our wealth from changes in price
levels.
Since Irving Fisher (1930) published his theory of interest, investors have viewed equities as a sound vehicle for protection from
inflation. However, empirical evidence collected since the late 1970s
(which will be detailed in this chapter) shows that this may not
be the case: in the short run, stock returns do not adjust for inflation. That means that an increase in inflation is not accompanied by
a similar increase in stock returns. However, that is not the only
part of the story. In the long run, there is evidence that returns
on stocks will partly compensate for inflation. It is also possible to
make tactical shifts into industries that do better during inflationary
periods.
In this chapter, we review the theory and evidence behind the
relationship between inflation and stock returns. To set the stage,
Table 13.1 shows the average (over the period 19952010) equity
returns (nominal and real) and inflation rates for 23 of the worlds
largest economies. Real equity returns are in general positive,
although four countries (Greece, Italy, Japan and New Zealand) had
negative average real returns over this period.
To get a better sense of the data beyond simple averages, we
include histograms of nominal and real return data, and inflation
data, for a subset of the countries included in Table 13.1. The nominal
and real return histograms are given in Figure 13.1, and the inflation histograms are given in Figure 13.2. We chose the US, Germany,
Japan, India, Mexico and Brazil as representative of the developed
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Table 13.1 Nominal and real returns (in percent) by country

(19952010)
Nominal
Real
Inflation
Nominal
Real
Inflation
Nominal
Real
Inflation
Nominal
Real
Inflation
Nominal
Real
Inflation
Brazil
Canada
Chile
Mexico
US
17.30
7.84
8.77
7.25
5.33
1.82
9.02
5.05
3.78
17.42
7.22
9.51
6.30
3.88
2.32
Austria
Denmark
France
5.90
4.13
1.70
9.78
7.68
1.96
4.40
2.86
1.50
7.43
5.96
1.38
Ireland
Israel
Italy
Norway
Spain
4.72
2.25
2.41
12.21
8.36
3.55
1.37
3.40
2.11
9.68
7.53
2.00
7.26
4.44
2.69
Switzerland
UK
Australia
China
India
5.60
4.72
0.84
4.09
2.14
1.91
5.85
3.13
2.64
13.86
10.99
2.58
10.91
4.21
6.43
Japan
Korea
New Zealand
4.10
4.03
0.08
4.32
0.87
3.42
Germany Greece
3.04
1.00
4.09
0.75
1.56
2.35
Nominal returns data are obtained from Bloomberg for the broadest stock
index with the longest history for each country. Inflation is the Consumer
Price Index (CPI) as measured by the Organization for Economic Cooperation and Development (OECD). Inflation data were obtained from
the Federal Reserve Bank of St Louis.
economies (the former three countries) and emerging markets (the

latter three countries). Overlaid on each histogram is a curve fitted
to the data using the estimated mean and variance of the countryspecific data. We notice immediately that the fitted curves are not
Gaussian. The US and Germany return charts exhibit negative skew,
while Japan has positive skew. Returns in India are close to normally
distributed, but Mexican returns appear to be negatively skewed and
Brazilian returns slightly positively skewed.
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INFLATION AND EQUITY RETURNS
Figure 13.1 Nominal and real annual returns

40
30
(a)
30
(b)
20
% 20
10
10
0
0
0.5
30
0.5
0.5
40
(c)
0.5
1.0
(d)
30
20
20
%
10
0
1.0
10
0
0.5
0.5
1.0
1.0 0.5
30
25 (e)
0.5
1.0
1.5
(f)
20
%
20
15
10
10
5
0
1.0
0.5
0
0.5
Returns
1.0
Returns
(a) US, (b) Japan, (c) Germany, (d) India, (e) Mexico, (f) Brazil. Solid line, nominal (estimated); dashed line, real (estimated). Grey histogram, nominal; black
histogram, real.
Inflation in developed countries follows a very different pattern

from that in emerging markets. We have grouped the inflation in
the three developed countries into one histogram in Figure 13.2,
but the inflation for the emerging markets economies are displayed
individually. The developed countries have inflation patterns that
are very similar, though their means are different.
The US experienced inflation rates of about 3% per annum on
average, while those for Germany were about 2% and those for Japan
were only slightly higher than 0%. Occasionally these countries have
experienced deflation, but it is quite rare, since the central banks of
each country target positive rates of inflation.
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Figure 13.2 Annual inflation rates

25
40
20
30
15
% 20
10
10
0
5
0.02
0
0.02 0.04
Annual inflation
0.06
0.05 0.10 0.15

Annual inflation
0.20
80
200
60
150
% 40
100
20
0
50
0
0.5
1.0
Annual inflation
1.5
0.2
0.4
0.6
Annual inflation
0.8
Inflation in: (a) US, Germany and Japan (solid line, US; dashed line, Germany;
dotted line, Japan; light-grey histogram, US; dark-grey histogram, Germany; black
histogram, Japan); (b) India; (c) Mexico; (d) Brazil.
The emerging markets economies all have much higher mean

inflation, and India is the only one of the three with a normal distribution. Indias mean inflation is approximately 6.5%, but has ranged as
high as 15% and as low as 2.5%. Brazil and Mexico, on the other hand,
have extremely fat right tails and distributions that do not follow a
recognisable pattern. It is likely that these two countries have followed different inflation regimes, as high inflation rates were tamed
in the 1990s. This is an important point to remember, as some literature (detailed throughout this chapter) points to equities providing
better protection from inflation in high inflation countries and worse
protection in low-inflation countries.
In the following, we shall discuss some introductory concepts,
specifically the Fisher hypothesis (which first laid out the expected
relationship between stock returns and inflation), the distinction
between expected versus unexpected inflation and the equity
inflation puzzle, ie, the negative relationship between stock returns
and inflation, which has been documented in many empirical studies. Next, we shall present various equilibrium-based theories that
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aim to explain the negative correlation between stock returns and

inflation, and review stock pricing theories that do the same. Finally,
evidence of the efficacy of equities as a hedging device, including
the best hedging methods, will be analysed.
FISHERS HYPOTHESIS
Irving Fishers hypothesis (Fisher 1930) held that the nominal interest rate rN , what might be called the risk-free return, is composed
of a real component rR , plus expected inflation iEXP the time horizon
under consideration
(13.1)
rN = rR + iEXP
Fisher believed that the real interest rate was independent of
monetary effects and therefore, in Fishers theory, independent
of expected inflation. Therefore, the nominal rate should adjust
one-for-one with inflation
rN
=1
iEXP
(13.2)
According to a simple capital asset pricing model,1 the required

return on a stock rstock is equal to the nominal rate plus the product
of the stock beta coefficient () and the equity risk premium (the
latter being the difference between the required return on the overall
equity market rMkt and the nominal rate r N itself)
rstock = r N + risk premium = rN + [rMkt rN ]
(13.3)
Therefore, assuming that risk premium does depend on expected inflation, stock returns should also increase one-for-one with
expected inflation
rN
rstock
=
=1
(13.4)
iEXP
iEXP
Furthermore, if we assume that itself is not dependent on expected
inflation, the key empirical issue is the relationship between the
equity risk premium and inflation, or equivalently between inflation
and the overall market return rMkt .
Although many of the simplifying assumptions above have been
challenged by the empirical data, Fishers hypothesis provides a
simple yet powerful starting point in the analysis of the relationship
between stock returns and inflation. Specifically, this equation predicts nominal stock returns to be positively correlated with ex ante
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expected inflation. Indeed, it is precisely when returns and inflation

fail to behave according to theory that Fishers equation provides a
uniquely useful framework to identify what the reasons behind that
failure might be. In particular, failures of Fishers equation might
stem from a combination of factors, including
dependence of real rates or real economic activity on inflation
and the business cycle,

variation of linked to inflation or the business cycle (eg, for
cyclical versus non-cyclical companies), and

variation in the risk premium (eg, in high- versus low-inflation
regimes).
EXPECTED VERSUS UNEXPECTED INFLATION
Expected inflation is the percentage price increase that investors
think will take place over a certain time period in the future, based
on information available in the present. By definition, only expected
inflation can be incorporated into the required return calculation for
an asset. However, unexpected inflation, or the difference between
expected and actual inflation, has potential consequences for stock
returns.
Among its effects, unexpected inflation constitutes a wealth transfer from net creditors to net debtors, increases the real tax burden
of firms with significant fixed assets and inventory and it indicates
that future inflation may be different from previous expectations. If
unexpected inflation is positive, then future expected inflation will
increase and cause an increase in required returns.
The transfer of wealth from creditors to debtors results because
contracts are written in US dollar terms. This transfer will exist for
all dollar-denominated contracts that do not adjust for unexpected
inflation, or are renegotiated infrequently. Thus, unexpected inflation may also constitute a wealth transfer from the labour force to the
shareholders because wages will typically not rise as fast as inflation,
so profit margins should improve at least over the short term. The
stock-return effect on any specific firm is a combination of several
effects and thus unclear a priori.
In addition to the automatic effects illustrated above, inflation
surprises might also lead to government intervention to counteract
high inflation or avoid deflation. Examples include Nixon-era price
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controls, the dramatic increases in interest rates, such as under Paul

Volckers leadership at the Federal Exchange in the 1980s, or quantitative easing policies employed by central banks to boost market
liquidity (for example, during and following the 20089 global recession). In general, price controls interfere with production and thus
lead to stock price losses. Higher interest rates lift the required return
on assets in general, while greater liquidity in the financial system
acts in the opposite direction.
THE EQUITYINFLATION PUZZLE
The equityinflation puzzle is, in fact, bad news for stocks. It has long
been the contention of various investors and financial advisors that
stocks are a good hedge against inflation. Based on Fishers hypothesis and the nature of stock valuation (eg, discounting of future cashflows generated by a real asset), this contention has intuitive merit.
Unfortunately, the empirical evidence does not confirm the intuition.
In fact, stock returns and inflation often move in opposite directions.
As we shall find out, though, this is a controversial topic, and there
are still strategies that investors can use to protect their wealth from
inflation.
The remainder of this chapter is divided into three sections. The
first explains theories of inflation and stock returns from an economic equilibrium perspective where, at least in the long run, market prices are set by the balance or equilibrium relationships linking
several interacting agents and economic factors. Equilibrium in this
context means that the actions taken by households and by businesses are stable in the long run. Thus, any change in the economic
variables will cause these equilibrium relationships to adjust. In general, these theories explain that the observed negative correlation is
a result of spurious correlation because stock returns and inflation
react differently to economic fundamentals like real productivity
growth.
The second section outlines stock valuation-based theories and
reviews the currently popular inflation illusion hypothesis. This
hypothesis suggests that the negative correlation between inflation
and stock returns is due to investor irrationality. We also discuss an
alternative hypothesis, ie, that correlation is driven by demand and
supply shocks instead.
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The final section discusses the empirical literature, and explores

the efficacy of stocks as an inflation hedge, tactical asset allocation
and the differences between high- and low-inflation regimes.
Equilibrium-based theories of inflation and asset returns
Equilibrium models of the inflation process tend to be complex and
designed for the specific purpose the author has in writing the paper.
As such, it is not sensible to review every model nor is it possible to
provide general models.
This said, the key empirical findings that equilibrium theories of
inflation and asset returns are attempting to explain are that
1. real stock returns are negatively correlated with both expected
and unexpected inflation, and
2. real stock returns are positively correlated with money growth;
in other words, real stock returns tend to increase with the
quantity or velocity of money.
This seems in contradiction to the inverse relation between inflation
and stock returns, and hints to the fact that shocks to output production and shocks to the demand for money might have quite different
effects. Both shocks can cause inflation, but negative supply shocks
reduce future stock returns, while positive demand shocks are at
least neutral for stock returns, and may be positive. These empirical
facts indicate that stock returns are not the inflation hedge they are
popularly thought to be. This is a post-World War II phenomenon
that does not square with Fishers hypothesis and the concept of
common stock as the present value of future income generated by a
real asset.
As for point 1 above, several theories have been advanced to
explain the negative relationship between stock returns and inflation. Fama (1981), in one of the earliest attempts to explain the negative correlation, showed that it arises because of an omitted variable bias. The basic argument is that both inflation and real stock
returns are related to future real activity: inflation negatively and
stock returns positively. Thus, the documented negative relationship is actually a spurious correlation due to the omission of real
activity from the model. In other words, when an inflation surprise
occurs (on the upside), equity values tend to decrease because of
the markets anticipation of a slow-down in future real economic
output.
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Because Famas model does not account for all the negative correlation between unexpected inflation and stock returns, Geske and
Roll (1983) proposed an extension to Famas theory. Their argument
focuses on the effect of stock market returns on government finances.
Essentially, government revenues are comprised of personal and corporate taxes, which respond to expected economic conditions in the
same direction as the stock market. Thus, stock market returns anticipate changes in government revenue. Government expenditure, on
the other hand, is largely fixed. Clearly, government deficits are
countercyclical (they tend to decrease when the economy is strong,
and increase when the economy is weak). Geske and Roll hypothesise that a decrease in the stock market will lead to higher deficits
and, given that under such circumstances the Federal Reserve System will have an incentive to monetise the growing debt, this in turn
will lead to growth in-the-money supply and higher inflation. Thus,
the measured correlation between stock returns and inflation is negative. This hypothesis is also called the reverse-causality link, as
it is declining stock prices that cause inflation to rise, and not the
other way around.
Regarding point 2 above, Danthine and Donaldson (1986) developed a general equilibrium model and showed that common stocks
are not a good hedge against non-monetary inflation, ie, a price level
increase caused by a negative supply shock (for example, oil prices in
the 1970s); however, common stocks are a good hedge against monetary inflation (typically associated with a positive demand shock2 )
over the long run. This study differentiates between inflation caused
by supply shocks and inflation caused by demand shocks (the latter being more equity friendly than the former) and recognises the
importance of the horizon used in the analysis, as different dynamics
might be at play in the short and the long term.
Marshall (1992) developed and estimated a representative agent
model where agents hold a mix of money, equities and bonds as
assets. The value of money is that it reduces the costs of consumption
transactions. Agents seek to maximise the present value of expected
consumption utility. The agents do not have income; rather, they are
constrained by the amount of shares and bonds they hold. Agents
can lend and borrow (issue bonds) at the risk-free real rate of interest. Finally, increases in money supply are exogenous (the money
supply function follows a stochastic process) and new money is
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distributed directly to agents as a lump-sum transfer. The importance of Marshalls model is that it does not include any irrationality or market inefficiencies, which other authors have suggested as
explanations of the negative correlation between real equity returns
and inflation (see the discussion in the next section regarding inflation illusion). It is clear that the Fisher hypothesis is violated by
the negative correlation between expected inflation and expected
stock returns. Marshalls contribution shows that this violation of
the Fisher hypothesis arises because of the importance of money
for transactions. Marshalls model also shows that the hypothesis of
Fama (1981) is correct, in that it is fluctuations in the real economy
that cause equity returns and inflation to move in opposite directions. Finally, an increase in expected inflation that arises due to an
increase in expected money growth causes agents to hold less money
and therefore increase balances held in equities or bonds. Marshalls
model suggests there should be limited or no effects from money
supply-induced inflation and equity returns.3
While the theoretical work reviewed to this point does not rely
on financial intermediaries, the work of Boyd et al (2001) points to
the banking sector as an important agent for transmitting inflationinduced problems to the economy as a whole, including equity
prices. In addition to new insights, they have one of the largest
data samples of any papers reviewed: 100 countries from 19601995.
Inflation affects the real activity through the banking sector because
higher inflation, even if predictable, exacerbates information asymmetries that already exist in credit markets. As inflation increases, the
informational frictions become more important and result in credit
rationing. With fewer loans being made, fewer projects can be started
and thus real output growth declines.
Boyd et al (2001) showed that countries with high inflation (their
cut-off is 15% per year) have less developed financial sectors than
countries with low inflation. This leads to some differences in the
effects of inflation on equity returns. In low-to-moderate inflation
countries, inflation rates and stock market liquidity and trading volume are inversely correlated, while inflation is positively correlated
with equity return volatility. But, above 15% inflation per annum,
the correlations between inflation and equity market activity disappear. Finally, below 15% inflation they observed no correlation
between nominal equity returns and inflation, but above 15% they
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found a one-to-one positive correlation between inflation and nominal equity returns. Thus, when examining foreign countries for
potential investment, keeping in mind the 15% inflation cut-off is
likely to be helpful.
Stock price based theories of inflation and asset returns
It is helpful to review the Gordon (1962) growth model of stock
pricing, which states that the value of a share of equity today is the
present value of the dividends accruing to the share in perpetuity.
Formally
Dt+1
(13.5)
Pt = stock
r
g
where Pt the current price of one share, Dt+1 the expected dividend
next period, rstock is the required return on the stock and g is the
expected growth rate of the dividend. The Gordon model implies
that stock prices should not be affected by expected inflation, as
the inflation contribution cancels in the difference rstock g. However, we know that empirical data does not support this conclusion.
The previous section covered various economic reasons for this phenomenon. This section explores reasons specifically related to stock
pricing models.
There are three possible reasons for stock prices to be affected
by inflation, according to the Gordon model. The first is that the
Fisher hypothesis for dividend growth rates is incorrect, and real
dividend growth is actually a function of expected inflation, among
other things. Second, the Fisher hypothesis for stock returns is incorrect, and the required real stock return is affected by expected inflation. Finally, there is the inflation illusion hypothesis, developed
by Modigliani and Cohn (1979).
The inflation illusion hypothesis states that investors mistakenly
extrapolate past nominal dividend growth into the future, even
when inflation is changing. For example, if inflation is expected to
increase, investors operating under the inflation illusion hypothesis
will increase their estimate of nominal required return rstock but will
not adjust their estimate of nominal growth. This leads to lower stock
prices, and a negative correlation between inflation and stock prices.
The reverse is also the case: when expected inflation decreases, stocks
become overvalued.
Sharpe (2002) provided the first set of results in our overview. He
found that the negative relationship between stock valuation and
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expected inflation is due to two effects. First, an increase in expected

inflation lowers the expected growth of real earnings, which is similar to the negative correlation between real activity and inflation
discussed in the previous section. Second, increased expected inflation increases the required real returns, probably because higher
inflation is associated with a more volatile stock market, thereby
increasing investors required return. Both of these constitute violations of the main assumption underlying the Fisher equation, that
is real variables are not affected by inflation. Higher required stock
return and lower expected dividend growth both combine to reduce
present stock values.
Using the price/earnings (P/E) ratio as his dependent variable,
Sharpe documented an initial coefficient on ten-year inflation of 20,
which indicates that an increase of 1 percentage point in the expected
ten-year inflation rate is associated with a 20% decline in the P/E
ratio. The inclusion of estimates of long-term real dividend growth
rates and expected real bond yield explain the effect of inflation
on the P/E ratio. In his analysis of long-run real expected returns,
Sharpe found that the effect of inflation on the expected real equity
return, ie, rR + [r Mkt rN ] operates through the real bond yield rR .
In other words, expected inflation has no effect on the equity return
premium [rMkt rN ]. Arguing against Sharpe were Campbell and
Vuolteenaho (2004): they argued that the components identified by
Sharpe (2002) do not explain the stock-returninflation relationship
as well as the inflation illusion hypothesis of Modigliani and Cohn
(1979). The ModiglianiCohn hypothesis states that investors do not
incorporate inflation into their nominal dividend projections correctly. Specifically, investors do not adjust the nominal dividend
growth rate in line with the nominal discount rate, even if inflation
should affect both to the same degree.
Campbell and Vuolteenaho (2004) presented evidence against
Sharpes findings and in favour of the inflation illusion hypothesis.
To analyse the data, Campbell and Vuolteenaho used the dividend/
price ratio as the dependent variable, and have as independent variables the excess (over the risk-free rate of return) growth rate in
dividends, a subjective risk premium,4 and a mispricing term that
is essentially the error term from the regression. Qualitatively
Dt+1 def stock
= r
gex ante risk premium + (gex post rN ) +
Pt
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Note that the independent variables on the left represent realised historical data (for example, the realised dividend growth rate gex post ),
while the dividend price ratio on the left embeds (by definition)
future expectations of the same quantity, ie, gex ante . The motivation
for the regression is that if the dividend growth rate and subjective
risk premium explain the dividend/price ratio, then the hypothesis
of inflation illusion is rejected. If the error term is significant and
positively related to inflation, then the hypothesis of inflation illusion cannot be rejected. The results from the analysis of Campbell
and Vuolteenaho (2004) indicate that the realised dividend growth
rate gex post and inflation are positively related. Thus, empirically
speaking, inflation does not have an adverse impact on the realised
real growth of dividends. Also, the (subjective) risk premium is not
related to inflation, so investors do not become more risk averse
when inflation increases. The mispricing component is strongly positively related to inflation, and this constitutes evidence in favour of
the inflation illusion hypothesis (ie, that the ex ante projection for
nominal dividend growth does not fully account for inflation, so
that r stock gex ante is a positive relation to inflation). Campbell and
Vuolteenaho also suggested that, while inflation illusion is present
in the short run, it should diminish over the long run (longer than
one year); therefore, equities tend to be a poor inflation hedge in the
short run, but a better hedge over the long run. This is consistent
with results that we shall review in the next section.
The previous sets of results involve expected inflation. But it might
be the case that the inflationequity return correlation is caused by
unexpected inflation. Sudden price changes in a commodity or service might occur because of a sudden and unexpected change in
production. Negative supply shocks are those that cause supply to
decrease and thus the price of the commodity to increase. Positive
supply shocks are the opposite, and are often termed technology
shocks because of the close positive correlation between technological innovation and productive capacity. If the commodity in question is particularly ubiquitous in the economy, like crude oil, this
price shock can work its way through the economy generally, thus
showing up as inflation.
Demand shocks are sudden changes in the demand for a certain
commodity or service. Of course, demand shocks have the opposite
effect to supply shocks. A particularly important type of demand
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shock that affects the whole economy is a sudden increase in the

demand to hold cash, rather than spend it on goods and services.
Such a demand shock can show up as a recession or decrease in total
expenditure (and thus lower GDP, all other things being equal). A
demand shock whereby people want to hold less cash and want
to spend more can show up as price inflation. There is not a great
deal of evidence regarding the importance of demand shocks for the
inflationequity-return relationship, but supply shocks are another
matter.
Hess and Lee (1999) explored the explanatory power of supply
and demand shocks in resolving the inflationstock-return puzzle.
Supply shocks are generally real output shocks, which generate a
negative inflationstock-return correlation. Demand shocks, on the
other hand, cause a positive correlation between inflation and stock
returns. Hess and Lee provided evidence for the US, UK, Germany5
and Japan. Except for the US prior to World War II, supply shocks
dominate the sample, generating the observed negative correlation.
Lee (2010) revisited the inflation illusion hypothesis and found
that it cannot explain the inflationequity-returns relationship that
existed prior to World War II, although it fits the post-war data in
the US and several other countries. Lee proposes a two-regime
hypothesis that he finds explains the data for the pre- and post-war
periods in his sample of countries. The two-regime hypothesis follows from Hess and Lee (1999). The period before World War II is
dominated by demand (ie, monetary) shocks, which created a positive relationship between inflation and equity returns prior to World
War II. Conversely, supply shocks created a negative relationship
between inflation and equity returns in the post-war sample. The
negative correlation between inflation and equity returns caused by
supply shocks is a consequence of the negative effect that higher
prices (especially energy prices) have on production and real activity. This is reminiscent of Fama (1981) and Danthine and Donaldson
(1986).
The inflation illusion hypothesis is also challenged by Wei (2010).
Arguing that the vector autoregression (VAR) method used by
Campbell and Vuolteenaho (2004) overstates the importance of the
residual term, and thus the solidity of their conclusion, Wei prefers
a general equilibrium framework, and is able to show that technology shocks can yield the same empirical predictions as the inflation
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illusion hypothesis. Weis model generates a positive correlation

between dividend yield and inflation through technology shocks,
which operate on the productive sector and thus dividend growth.
Therefore, the correlation between inflation and equity returns is
spurious. Weis model follows similar reasoning to Fama (1981) and
Marshall (1992) and thus is not a stock-price based model. It is discussed in this section because it seeks to directly refute the inflation
illusion hypothesis.
In the next section, we shall review the empirical evidence on
the efficacy of equities as an inflation hedge, as well as methods of
improving their performance as an inflation hedge through tactical
asset allocation and other portfolio management techniques.
Inflation and stock returns: empirical evidence
Inflation hedge effectiveness
Schwert (1981) examined the effect of unexpected inflation on stock
returns. He found a negative, but small, correlation between unexpected high inflation and stock returns and showed that the market
reaction was distributed over the days surrounding the announcement of the Consumer Price Index (CPI) data, but the daily changes
were too small to offer a profitable trading opportunity.
Solnik (1983) offered evidence based on a short time period (1971
80), but a broad selection of countries (the US, Japan, the UK, Switzerland, France, West Germany, the Netherlands, Belgium and Canada).
Solnik tested for a correlation using real stock returns. According
to the Fisher hypothesis, real stock returns should be unrelated to
inflation. Solnik found that real and nominal stock returns are negatively related to unexpected inflation and suggests this is because
unexpected inflation leads to changes in expected inflation in the
future. He also noted a reverse causality: increased stock returns
signal negative revisions in expected inflation.
Kaul (1987) offered empirical evidence in favour of Fama (1981)
and Geske and Roll (1983) using evidence from the US, Canada,
the UK and West Germany. This empirical data indicates that the
post-war experience of negative correlation between inflation and
stock returns was common to industrialised countries. It also confirms that the negative correlation was due to activity in the monetary sector: specifically countercyclical monetary responses used to
finance deficit spending. If central banks were to follow a procyclical
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monetary policy, allowing money supply to rise and fall with gross
national product, then stock returns and inflation would be positively related. Kaul (1987) shows this is the case for the depression
period in the US and Canada.
In a follow up paper in 1990, Kaul considered the impact of two
different types of monetary policy regimes on the stock-return
inflation correlation. There are two ways that central banks carry
out their mandate of price stability and, in the case of the US Federal
Reserve (the Fed), the additional mandate of full employment. The
central bank can target a specific growth rate in the monetary base, or
the central bank can target interest rates, like the discount window
rate or the overnight federal funds rate. The monetary base is the
total currency held by the public plus vault cash and deposits held
by Federal Reserve banks. The discount window rate is the interest
rate charged by the Fed on overnight lending directly from the Fed
to its member banks. The federal funds rate is the rate at which banks
lend to each other in the overnight lending market.
Kaul (1990) identified periods in which central banks in four countries (the US, Canada, the UK, West Germany) follow the two different methods discussed above. When monetary policy targets money
growth directly, there is no clear link between money supply and economic activity, and thus there should be no significant correlation
between inflation and equity returns.
Kaul followed Geske and Roll (1983) in assuming that if central banks use interest rate targeting as the mechanism of implementing policy, then the central banks will follow a countercyclical policy. This is because interest rate targeting leads the Fed to
monetise government debt, giving rise to the mechanism identified
by Geske and Roll (1983) and leading to the negative correlation
between stock returns and inflation. Kauls results confirm that the
reason for the apparent shift from no relation or a positive relation
between inflation and equity returns to a negative relation is due to
the shift in how the central banks implement their mandates. In the
US and Canada, central banks moved from targeting money supply to focusing on interest rates, especially after the oil crisis in the
1970s. Moreover, Kaul highlighted that, unlike previous work, it is
the interaction of money demand and money supply that governs
the relationship between inflation and equity returns, not just money
demand.
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The message of Kaul (1987, 1990) is that in industrialised countries where the central bank uses interest rate management to fulfill its objective of price stability (and full employment as in the
US), investors should expect a negative relationship between stock
returns and inflation, both expected and unexpected. Therefore,
stocks will not be a satisfactory inflation hedge in the short run.
Chang and Pinegar (1987) investigated the effect of security risk
on the relationship between stock returns and inflation. They found
that the riskier the security, as measured by the market beta, the
more negative the correlation between inflation (expected and unexpected) and real stock returns. However, their results are based on
the model developed by Geske and Roll (1983), which posited a monetary growth mechanism rather than an interest rate management
mechanism. Thus, it is not clear if Chang and Pinegars results are
applicable to the environment of the 2000s.
In the spirit of Danthine and Donaldson (1986), Boudoukh and
Richardson (1993) offered the first exploration of the stock-return
inflation relationship over a long horizon. They used stock returns
from 1802 to 1990 and a five-year time horizon. Previous studies
used post-World War II data and month/quarter/year horizons.
For the longer time horizon, Boudoukh and Richardson (1993)
found that stock returns do compensate for inflation, but not fully.
A 1% increase in inflation yields a 0.5% increase in nominal stock
returns over a five-year period. The one-year horizon conforms to
previous studies, where inflation-hedging performance is generally
poor. Thus, over the long run, stocks offer some inflation protection.
They confirmed this result for the UK over the period 18201988.
Gregoriou and Kontonikas (2010) updated the work of Boudoukh
and Richardson (1993) with a shorter (19702006) but wider (16
OECD countries) sample. Their findings indicate that over the long
run (ie, 10 to 16 years), annual elasticity of stock prices to consumer
goods prices is not significantly different from unity. That means
that, over the long run, stocks will provide a nearly one-to-one hedge
against inflation. We have found that these results are the strongest
in favour of stocks as an inflation hedge.
Schotman and Schweitzer (2000) derived optimal hedge portfolios for various assumptions regarding inflation persistence and
the long-run relationship between equity returns and inflation. Their
results indicate that only when inflation is fairly persistent and stock
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returns have a positive relationship with inflation (a beta of 0.7 or

higher) will stocks offer a reasonable inflation hedge, and then only
over very long time horizons: 15 years or more. Given other findings
about the correlation between stock returns and inflation, Schotman
and Schweitzers findings are not favourable to the use of stocks to
hedge against inflation.
In a very interesting paper, Amihud (1996) tested the various
hypotheses that purport to explain the negative correlation between
inflation and stock returns. It is interesting because Amihud uses
Israel as the test case. Contracts in Israel are specified in real terms;
for example, tax brackets and government debt are linked to the
CPI; bank yields and other interest rates are also quoted in real
terms, which obviates the inflation illusion. Thus, when Amihud
found a negative correlation between inflation and stock returns in
Israel, it could only be because higher inflation leads to decreased
real activity.
Goto and Valkanov (2002) pursued the monetary shock angle further by exploring the effects of unanticipated changes in the federal
funds rate. They argued that a surprise increase in federal funds rate
causes the total return on stocks6 in excess of the risk-free rate to
decrease, and increases both expected and observed inflation. Their
findings indicate that monetary shocks can explain between 20% and
25% of the covariance between excess returns and inflation. Thus,
keeping an eye on the Fed is important for forecasting stock returns
and inflation.
In the early 2000s the focus shifted to the effects of inflation across
the business cycle. Inflation news carries different information in
booms and recessions. Adams et al (2004) used intra-day trade7 data
to show that a 1% increase in inflation in a weak economy causes a
decline much greater than 1% in stock returns; in a strong economy
this decline is only about 0.5%.
Knif et al (2008) examined the effects of good and bad inflation
news across the various stages of economic growth, which are categorised as: growing, stable and slowing. They examined cumulative abnormal returns (CAR) over a 20-day window centred on the
inflation announcement day. During a period of economic growth,
investors appear to take a dim view of unexpectedly high inflation,
with a CAR of 9.43. So an unexpected inflation of 1% above the
expectation would lead to a decrease in the S&P 500 of 9.43%. This is
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exceptionally high. On the other hand, a negative inflation surprise

has a CAR of 1.95, but it is not statistically significant. The pooled
result is 2.00, and is also not significant. Thus, in a rising economy, negative surprises tend to occur more frequently than positive
surprises, but positive surprises are very damaging to the market.
In a stable period, negative inflation shocks dominate and lead
to negative market returns of around 6.5% for a 1% difference
between expected and actual inflation. Positive inflation shocks are
not statistically significant in stable periods. In a slowing period, no
inflation shock was found to be statistically significant, although
there was a positive effect of negative shocks on the stock market. This is in contrast to Adams et al (2004), who highlighted
the importance of the measurement horizon. Ultimately, Knif et al
(2008) showed that the state of the economy matters greatly when
considering inflation effects on the stock market.
Finally, the effects of the business cycle on inflation were discussed
in a working paper by Wei (2009). He confirmed the importance
of these effects, but illustrated two interesting points that can help
with hedging. He noted that firms with lower book-to-market ratios
(which are typically characterised as growth firms) and mediumsized firms have a higher negative correlation with unexpected
inflation; thus, choosing large value firms instead may offer further
hedging against inflation surprises.
Tactical asset allocation in relation to inflation
Pearce and Roley (1988) examined the role of various firm characteristics in determining individual equity response to unexpected
inflation. They found, as do others, that the average response to
unexpected inflation is negative. They had a short sample period
(19771982) and used only 84 firms. Thus, their results may not applicable to the entire market. Nevertheless, it is worthwhile exploring
potential avenues for improved performance against inflation. Their
results indicate that firms with high inventories experience a more
negative response to inflation if they use the first in, first out (FIFO)
method, as this understates cost of goods sold and therefore overstates taxable income, resulting in higher taxes. This effect does not
appear for firms that use the last in, first out (LIFO) method for
inventory valuation. Firms with more debt experience a positive
wealth effect if inflation is unexpectedly high. The same is true for
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firms with large pension expenses (if the latter are fixed in nominal terms). Depreciation does not appear to have any significant
effect. Thus, to summarise, if we want a better inflation hedge, we
should avoid firms that carry large inventories, and seek to hold net
debtors.
Boudoukh et al (1994) investigated the negative correlation by disaggregating the stock market into industries. They found that, in the
short run, non-cyclical industries tend to have a positive correlation
with expected inflation, while cyclical industries have a negative
correlation. Over the entire sample in their paper (19531990), most
industries have a positive correlation. It appears that those industries
that are related to consumer goods have a much stronger relationship
to consumer inflation than industries that are related to producers
goods. Thus, if we are looking for an inflation hedge over the long
run, it is best to focus on industries such as tobacco, apparel or food
and beverage.
Ely and Robinson (1997) updated the literature by taking an international view, offering evidence in favour of stocks as a hedge
against inflation. Their work indicates that focusing on the US may
deliver anomalous results. In the US, the efficacy of stocks as a hedge
against inflation depends on the source of inflation. If inflation occurs
because of a real output shock, then stocks do not offer a good hedge.
If it is monetary-induced inflation, then stocks do offer a good hedge.
Their work is based on a vector error-correction model (VECM) and
uses a 16-quarter horizon; it also covers Canada, Western Europe,
Australia, the UK and Japan. Many of the countries display their
own idiosyncratic relationship to inflation; thus, it is valuable for
the reader to investigate the specific country of interest. Some important observations are in order though. Canada and Italy both have
similar responses to the US to output shocks. Switzerland does not
offer protection from inflation, as stock prices decrease for both real
output and monetary shocks. Spain is the only country to offer solid
protection from output-related inflation.
Brire and Signori (2009) make an important contribution to the
asset allocation literature, but did not focus exclusively on equities.
Working in a real-return maximising portfolio environment, they
found that equity weight should be increased in a portfolio when
the targeted real return is greater than zero or the investment horizon
is long (typically two years or more).
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Bekaert and Wang (2010) and Ang et al (2011) offered evidence

regarding inflation betas for world equity markets and individual
equities, respectively. Inflation betas are estimated using a standard
factor model, where asset returns are modelled as a function of one
or more factors. It appears that inflation betas are not sensitive to
different factor specifications.
Bekaert and Wang (2010) confirmed much of the previously published research. Using one-year holding periods, they found that
developed markets have negative but insignificant inflation betas,
whereas emerging markets offer a near-perfect inflation hedge. This
is the case for both expected and unexpected inflation. Asia and
Africa stocks offer the worst expected inflation hedges, while North
American and EU stocks are the worst hedges against unexpected
inflation. Latin American stocks are a strong hedge against both
expected and unexpected inflation. Using longer horizons, up to
five years, also leads to similar conclusions.
Ang et al (2011) found that, while the US stock market in general
is not a good inflation hedge, certain individual equities may be.
They estimated the inflation beta for all stocks in the S&P 500 for the
period 1989 to 2010. They then sorted the stocks into quintile portfolios according to their inflation beta. The quintile with the highest
inflation beta had an inflation beta of 1.65. The lowest quintile had
an inflation beta of 2.22.
While their in-sample analysis is encouraging, they found that
past inflation hedges are not a guide to future inflation hedges, and
a firm that has a high inflation beta in the past is not guaranteed to
have a high inflation beta in the future. The quintile with the highest
inflation beta in-sample has only a 0.45 inflation beta out-of-sample.
There is also evidence of reversal, as the quintile with the lowest
in-sample inflation beta has an out-of-sample inflation beta of 0.52:
the highest recorded out-of-sample inflation beta.
High- and low-inflation differences
Most studies have focused on industrialised countries, where inflation tends to be low. Barnes et al (1999) examined a group of 25 countries, including several high inflation countries. Their sample covers
1957 to 1996. For most countries, nominal equity returns and inflation are negatively correlated. Austria, India, Italy, New Zealand
and the UK were found to have positive but low correlations. Equity
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returns in Chile, Israel, Mexico and Peru all have high positive correlations with inflation, and these are the four highest inflation countries in the sample. It appears that in high inflation countries there
is sufficient compensation through nominal equity returns to enjoy
a sound inflation hedge, as nominal equity returns adjust close to
one-to-one with inflation.
Barnes et al also explored the effects of spillover inflation from
the US into other countries. They found that for Germany,8 Luxembourg, the Netherlands, Peru, Portugal, Switzerland and the UK
there is a significant negative relationship between equity returns in
the country and US inflation. Only in the case of Israel is the spillover
positive. As Amihud (1996) showed, Israel is a special case due to
the differing institutional treatment of inflation.
Choudhry (2001) examined four countries that experienced high
inflation from the 1980s to the end of the 1990s: Argentina, Chile,
Mexico and Venezuela. Nominal stock returns were, on average,
higher than inflation. The efficacy of stocks as an inflation hedge
depends on the country under investigation. Argentina and Chile
offer the strongest inflation hedge, with Chile having a slightly larger
compensation than Argentina. Both are close to a one-to-one relationship between nominal returns and contemporaneous inflation.
Mexico also offers some inflation protection, but it is lagged one
month compared with Argentina and Chile. In Venezuela, however,
no inflation protection can be expected.
Choudhrys results are somewhat puzzling, in that Argentina has
the highest inflation in the group, and Chile has the lowest. This
may be because Choudhry does not calculate the source of the inflation: real output shocks or monetary policy. As we discussed earlier,
knowledge of the root cause of inflation is of utmost importance.
CONCLUSION
At this point investors may be quite discouraged regarding the inflation-hedging ability of equities: the bulk of the evidence does not
favour equities in this role. Nevertheless, there are many lessons to
be found in the above discussion.
First, in order to be a good hedge against inflation, equities should
be held over the long term. The Fisher relationship is more likely to
hold for investment horizons of five years or longer than for shortterm investment horizons. Thus, selling after a large inflation shock
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that causes equity prices to decrease is likely to be counterproductive. A better response would be to hold on and wait for equity prices
to restore themselves.
Second, equities in high-inflation regimes offer better inflation
protection than equities in low-inflation regimes. Latin America is
the test case for this in most of the literature. Even in the short run,
countries like Brazil and Argentina offer an inflation hedge much
closer to one-to-one than more developed economies such as the
US and the UK. Of course, we are trading off against other risks by
investing in emerging markets.
Third, there is some evidence that defensive industries, like
tobacco and food and beverage, provide better inflation hedges than
more cyclical industries. This evidence is not strong, however, and
out-of-sample testing suggests past inflation betas are not reliable
guides to future inflation betas.
Equities may not be a reliable inflation hedge in a low-inflation
environment. They do, however, offer a positive real return in most
countries, which is some protection against inflation.
1
The capital asset pricing model (Sharpe 1964; Lintner 1965).
In other words, easy monetary conditions (low real interest rates) increase the demand for
money and possibly consumption.
See Bakshi and Chen (1996) for an analysis of a broader array of model economies. They find
that conclusions similar to Marshalls hold for a variety of assumptions about utility functions
and money supply dynamics.
See Polk et al (2006) for a discussion of the subjective risk premium.
Evidence was provided for West Germany and reunified Germany after 1989.
Total return on stocks is measured as the value-weighted portfolio of all stocks included in
the Center for Research in Securities Prices (CRSP) database. This includes all stocks on the
NYSE, AMEX and Nasdaq exchanges.
Adams et al (2004) use a variety of time horizons, including calendar time (eg, 15-minute
intervals) and transaction time (tick data).
Results for West Germany and reunified Germany after 1989.
REFERENCES
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Frequency Stock Returns, The Journal of Business 77, pp. 54774.
Amihud, Y., 1996, Unexpected Inflation and Stock Returns Revisited: Evidence from
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Ang, A., M. Brire and O Signori, 2011, Inflation and Individual Equities, Working
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Bakshi, G. S., and Z. Chen, 1996, Inflation, Asset Prices, and the Term Structure of Interest
Rates in Monetary Economies, The Review of Financial Studies 9, pp. 24175.
Barnes, M., J. H. Boyd and B. D. Smith, 1999, Inflation and Asset Returns, European
Bekaert, G., and X. Wang, 2010, Inflation Risk and the Inflation Risk Premium, Working
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Boudoukh, J., and M. Richardson, 1993, Stock Returns and Inflation: A Long-Horizon
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Boudoukh, J., M. Richardson and R. F. Whitelaw, 1994, Industry Returns and the Fisher
Effect, The Journal of Finance 49, pp. 15951615.
Boyd, J. H., R. Levine and B. D. Smith, 2001, The Impact of Inflation on Financial Sector
Performance, Journal of Monetary Economics 47, pp. 22148.
Brire, M., and O. Signori, 2009, Inflation-Hedging Portfolios in Different Regimes,
Working Paper, URL: http://www.institutlouisbachelier.org/risk10/work/4302987.pdf.
Campbell, J. Y., and R. J. Shiller, 1988, The Dividend-Price Ratio and Expectations of
Future Dividends and Discount Factors, The Review of Financial Studies 1, pp. 195228.
Campbell, J. Y., and T. Vuolteenaho, 2004, Inflation Illusion and Stock Prices, The
American Economic Review 94, pp. 1923.
Chang, E. C., and J. M. Pinegar, 1987, Risk and Inflation, The Journal of Financial and
Quantitative Analysis 22, pp. 8999.
Choudhry, T., 2001, Inflation and Rates of Return on Stocks: Evidence from High Inflation
Countries, Journal of International Financial Markets, Institutions, and Money 11, pp. 7596.
Danthine, J.-P., and J. B. Donaldson, 1986, Inflation and Asset Prices in an Exchange
Economy, Econometrica 54, pp. 585605.
Ely, D. P., and K. J. Robinson, 1997, Are Stocks a Hedge against Inflation? International
Evidence Using a Long-Run Approach, Journal of International Money and Finance 16,
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Fama, E. F., 1981, Stock Returns, Real Activity, Inflation, and Money, The American
Fisher, I., 1930, The Theory of Interest (New York, MacMillan).
Geske, R., and R. Roll, 1983, The Fiscal and Monetary Linkage Between Stock Returns
and Inflation, The Journal of Finance 38, pp. 133.
Gordon, M., 1962, The Investment, Financing, and Valuation of the Corporation (Homewood,
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Gregoriou, A., and A. Kontonikas, 2010, The Long-run Relationship Between Stock
Prices and Goods Prices: New Evidence from Panel Cointegration, Journal of International
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Hess, P. J., and B.-S. Lee, 1999, Stock Returns and Inflation with Supply and Demand
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Kaul, G., 1987, Stock Returns and Inflation: The Role of the Monetary Sector, Journal of
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Kaul, G., 1990, Monetary Regimes and the Relation between Stock Returns and
Inflationary Expectations, The Journal of Financial and Quantitative Analysis 25, pp. 30721.
Knif, J., J. Kolari and S. Pynnnen, 2008, Stock Market Reaction to Good and Bad
Inflation News, The Journal of Financial Research 31, pp. 14166.
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Illusion Hypothesis, Journal of Banking and Finance 34, pp. 125773.
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Stock Portfolios and Capital Budgets. Review of Economics and Statistics 47, pp. 1337.
Marshall, D. A., 1992, Inflation and Asset Returns in a Monetary Economy, The Journal
of Finance 47, pp. 131542.
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Financial Analysts Journal 35, pp. 2444.
Pearce, D. K., and V. V. Roley, 1988, Firm Characteristics, Unanticipated Inflation, and
Stock Returns, The Journal of Finance 43, pp. 96581.
Polk, C., S. Thompson and T. Vuolteenaho, 2006, Cross-Sectional Forecasts of the Equity
Premium, Journal of Financial Economics 81, pp. 10141.
Schotman, P. C., and M. Schweitzer, 2000, Horizon Sensitivity of the Inflation Hedge of
Stocks, Journal of Empirical Finance 7, pp. 30115.
Schwert, G. W., 1981, The Adjustment of Stock Prices to Information about Inflation,
The Journal of Finance 36, pp. 1529.
Sharpe, S. A., 2002, Reexamining Stock Valuation and Inflation: The Implications of
Analysts Earnings Forecasts, The Review of Economics and Statistics 84, pp. 63248.
Sharpe, W., 1964, Capital Asset Prices: A Theory of Market Equilibrium under Conditions
of Risk, The Journal of Finance 19, pp. 42542.
Solnik, B., 1983, The Relation between Stock Prices and Inflationary Expectations: The
International Evidence, The Journal of Finance 38, pp. 3548.
Wei, C., 2009, Does the Stock Market React to Unexpected Inflation Differently across the
Business Cycle?, Applied Financial Economics 19, pp. 194759.
Wei, C., 2010, Inflation and Stock Prices: No Illusion, Journal of Money, Credit, and Banking
42, pp. 32546.
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14
Inflation Hedging through Asset and

Sector Rotation
Alexander Atti, Shaun Roache
International Monetary Fund
Long-term investors face a common problem: how to maintain the

purchasing power of their assets over time and achieve a level of real
returns consistent with their investment objectives. Both dimensions
of this problem are often considered together, but there remains
an active debate regarding the first, namely which types of assets
provide the most effective hedge against inflation.
The focus on inflation-hedging properties of different asset classes
sharpens and fades along with the fluctuations in inflation itself, but
what matters the most are unanticipated increases in the rate of inflation. Inflation cycles often begin with an unexpected rise a shock
that then persists. The most intense burst of interest and research
in this area followed the persistent rise in inflation through the 1970s
in several developed economies. Following the 20079 global financial crisis, and large inflows of liquidity by major central banks to
support economic activity and shore-up the financial sector, some
investors fear, at the time of writing, that inflation may at some point
again rise beyond expectations. This implies that inflation hedging
remains an important component of long-run investment policy. Of
course, inflation-linked bonds and derivatives are employed by market participants to hedge the effects of inflation, but their limited supply and liquidity across various markets still lead many investors to
rely on the indirect hedging properties of traditional asset classes.
In a previous paper (Atti and Roache 2009), we argued that the
inflation-hedging features of traditional core assets such as cash,
bonds, equities and commodities vary over time. For a long-only
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investor, this implies that static hedges may not grant adequate protection. At short horizons, commodities, and to some extent cash,
provide some protection against the eroding effect of unanticipated
inflation. Over the long run, their efficiency fades away, and nominal bonds start to offer better real return features as higher yields
provide a greater income cushion. Like many others (see, for example, Bodie 1976; Jaffe and Mandelker 1976; Fama and Schwert 1977;
Solnik 1983), we found that nominal equity returns are negatively
correlated to inflation.
This chapter extends our earlier work on long-run dynamics and
focuses on two issues. The first is to identify the most effective inflation hedges, going beyond broad asset classes, and looking into a
range of US domestic and international fixed-income instruments
and equity sectors. The second is to study asset class hedge performance after an inflation shock, over different time horizons, in order
to gain insight into possible active asset allocation/sector rotation
strategies.
In the context of a diversified investment portfolio, we use a multivariate vector error-correction (VEC) model, and calculate impulse
responses, so as to assess how inflation shocks affect asset and portfolio returns over time. We find that long-term investors could benefit from sector rotation amongst different categories of bonds and
equities. As expected, these properties experience large variations
over time.
WHAT CAN WE LEARN FROM PREVIOUS RESEARCH?
The theory surrounding this subject suggests that some traditional
asset classes should provide relatively effective inflation protection.
American economist Irving Fisher suggested that the nominal return
on short-term debt should comprise a real interest rate and compensation for expected inflation (Fisher 1930). In other words, Treasury bills (T-bills), commonly referred to as cash, or the risk-free
rate, would provide a perfect hedge when inflation is anticipated.
That is, short-term real interest rates would remain unchanged. This
hypothesis was subsequently challenged by Mundell (1963) and
Tobin (1965), who both argued that nominal interest rates should
change by less than one-to-one with changes in expected inflation,1
reducing the effectiveness of cash as a hedge. Atti and Roache (2009)
also found that cash is an imperfect hedge against unanticipated
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INFLATION HEDGING THROUGH ASSET AND SECTOR ROTATION
shocks in headline inflation. In contrast, the inverse relationship

between nominal bonds and inflation surprises is not a point of
debate. The return on bonds that pay nominal coupons and principal should decline when inflation increases over the maturity of
the bond (Balduzzi and Green 2001).
Much attention has been focused on real assets. During the
1970s, inflation rose and most of the major equity markets suffered
negative real returns, triggering a reappraisal of the view that equities, by offering a claim on the dividend stream of real assets, were
a good inflation hedge. Real estate and commodities are often considered to be good, albeit imperfect, inflation hedges, with much
empirical work backing this claim (see Atti and Roache 2009 and
references therein).
Fewer studies have examined the inflation-hedging properties of
asset classes in the context of complex and diversified investment
portfolios. Strongin and Petsch (1997) include a broad range of asset
classes commonly used by institutional investors. They find that
commodities and cash are the only assets that provide significant
protection against global inflation risk. They also note that international allocation on a currency-unhedged basis is likely to hedge
domestic inflation risk in an equity dominated diversified portfolio.
Brire and Signori (2010) note that inflation-hedging features of traditional assets vary across macroeconomic environments; Bekaert
and Wang (2010) show that traditional securities are, after all, poor
inflation hedges.
All may not be lost for investors seeking inflation protection, however. Advocates of active management rightly point out that not all
stocks are alike, and holdings of individual firms may offer better
hedging properties, this being also true of bonds and commodities.
In an investment bank report, Buckland (2008) suggests buying firms
that are causing the bout in inflation, and to look for companies operating in industries with inelastic demand. Ang et al (2011) find that
large caps, growth stocks and the oil, gas and technology sectors
offer better inflation protection in-sample, but out-of-sample analysis reveals unstable inflation betas, thus making it difficult to forecast
efficient inflation-hedging strategies.
We embrace the idea that a more selective approach within each
broad asset class is necessary to improve inflation-hedging results.
In this chapter, in addition to cash and commodities, we consider
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three types of nominal bonds, ie, government bonds, mortgagebacked securities and corporate bonds. Furthermore, we analyse
10 global equity sectors, as well as international diversification
through foreign equities and bonds.
MODEL SPECIFICATION
Many investors set their strategic asset allocation and their investment decisions based on expected risk and return over a relatively long time period, often five years or more. To assess asset
class inflation-hedging properties over such horizons, we use a cointegrated vector autoregressive (VAR) approach that allows us to
both identify whether asset class returns and inflation share common trends over the long run, and assess their dynamics over the
short run.2 Specifically, our objective is to estimate how different
asset classes react to an unexpected rise in inflation. An inflation
surprise is defined here as an increase in the US Consumer Price
Index (CPI) that is not anticipated by the VAR model. Clearly, market participants, who have access to a larger information set, may
anticipate what might be a surprise for any specific stochastic model
employed. However, one of the strengths of the VAR approach is that
it encapsulates a lot of information already. It can be written as
Zt = +
P

p=1
p Z tp + t
(14.1)
Each variable in the vector Z t is assumed to be a function of a

constant intercept (the vector ), and a specified number P of lags
(Z t1 , Z t2 , . . . , Z tP ) of its own value, and those of the other variables. The lag coefficients are collected in the P constant vectors
p , while the residuals are denoted by the vector t (the latter are
assumed to be normally distributed with a constant contemporaneous covariance matrix). We conduct the analysis using monthly
data, as can be seen in Table 14.1. As is customary with financial
time series, natural logarithms of the variables are taken. Not surprisingly, these time series turn out to be non-stationary and follow
stochastic trends.3
This type of model has many parameters that need to be estimated. Since our returns data set is relatively limited, estimating a
single model with all of the variables included at once leaves little
room for degrees of freedom and is therefore prone to over-fitting.
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We overcome this over-parameterisation problem by estimating

a large number of models with six variables (US inflation, US cash,
US bonds, global developed market equities, the (hedge) asset class
under investigation and a global commodity index) instead of one
model with a large number of variables. We assess the inflationhedging properties of different asset classes by rotating them in and
out of a six-variable model that always includes a core set of five
variables. In each case, the specific variables included in the estimated VAR model(s) will be highlighted as we address and use
each of the models. We will deal with six-dimensional multivariate
systems; thus, Z t , , p and t are always 6 1 column vectors.
The first step is to identify the optimal lag length, which in general
might be different for each of the specific models used in the chapter.
However, using standard selection techniques, such as the Akaike
and Bayesian information criteria (Akaike 1974), we find that P = 7
is a reasonable choice for all.
Following Grangers Representation Theorem, we can rewrite
Equation 14.1 in its equivalent VEC form (of order P 1)
Z t = +
J

j =1
j j Z t1 +
P
1
p Z tp + t
(14.2)
p=1
In this representation, the first log difference (or approximate

month-on-month percent change) in the vector of variables Z t is
as a function of
(i) the constant vector of intercepts representing deterministic
linear trends in the variables,
(ii) J constant coefficients j , determining the speed of adjustment
to long-term dynamic equilibrium relationships,
(iii) J cointegrated vectors j Z t1 , expressing stochastic equilibrium relationships and
(iv) P 1 lags of the changes in the vector of variables.
This VEC form is only valid if there are indeed long-run relationships among the variables. We find strong evidence, using standard
Johansen cointegration tests on the VEC representation in Equation 14.2, of at least two such relationships for a wide range of specifications. This indicates that among our variables there are at least
two common stochastic trends; therefore, J = 2. The results that
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follow are all based on the maximum likelihood estimation of the

VEC model described by Equation 14.2. Identifying the long-run
economic relationships that lead to these results is difficult, particularly as they typically involve a linear combination of many asset
class returns. This precludes the use of an intuitive identification
scheme for the cointegrating vector. However, both the role of the
trend rate of real economic growth and investor risk premiums are
likely to be important common factors behind long-run asset class
relationships.
To assess inflation-hedging properties, we use the estimated
model in Equation 14.2 to trace out the response of the total return
index of each asset class to a 1% shock to the US CPI. In other words,
we assume that month-on-month inflation rises by a greater-thanexpected 1% in month t, and study the evolution of all the variables
at several time horizons after the shock. This response reflects the
direct effect of the one-off inflation shock on the asset class, but also
all of the interactions between the other assets in the model. The
degree of confidence we have in these results is provided by the
standard errors, which were calculated using bootstrap methods,
and 500 replications.
As the error terms in Equation 14.2 are generally contemporaneously correlated, we have to find a vector of orthogonal residuals that can be interpreted as structural shocks. To fully specify the
latter, and identify the shocks to inflation, we impose a standard
Cholesky triangular identification scheme (ie, we specify an order
in variables, and a hierarchical structure of contemporaneous correlations). Specifically, we assume that none of the financial variables
affect inflation during the same month, which, given the well-known
stickiness of retail prices, is a reasonable assumption, widely used
in macroeconomic models (this is even true for retail petrol prices,
which typically lag changes in the price of crude oil). Variables are
ordered as follows:
1. inflation;
2. cash;
3. bonds;
4. global developed markets equities;
5. the asset class under investigation;
6. commodities.
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In other words, inflation shocks affect all other variables, cash return
shocks affect all variables except inflation, bond return shocks affect
all other variables except inflation and cash, and so on.
Although the ordering of variables is somewhat arbitrary, our
empirical results turn out to be insensitive to this ordering, largely
reflecting the low correlation of the reduced-form residuals from the
estimated model.4
DATA
In our study, we use monthly data from a variety of domestic and
international total return series. Total return series, in addition to
price returns, assume interest and dividend earned are reinvested
in subsequent periods. Wherever possible, we selected indexes (as
detailed below) that are widely used by investors as performance
benchmarks.5 The data set spans a time window from January 1970
to April 2011 (with a few exceptions highlighted in the paragraph
below).
For inflation, we use the CPI (all urban consumers) published
monthly by the US Bureau of Labor Statistics. For cash, we use the 90day US Treasury bills total return index provided by Global Financial
Data.6 For nominal bonds, we use the Barclays US Aggregate Index.
We also analyse a few sub-indexes within investment grade bonds,
namely the Barclays US Treasury Index, the Barclays US Mortgage
Backed Securities (MBS) Index, and US corporate bonds (measured
by the Merrill Lynch Corporate Master Index). The data set from
these four nominal bond indexes starts from December 1975.
While global equity indexes are widely available for the entire
period under review, global aggregate bond indexes are available
over a much shorter time span (since about 1990 for the Barclays Global Aggregate index). For the purpose of this chapter, and
because of the breadth of reliable data in the US bond market, we
opted to measure the sensitivity to inflation shocks of US-only investment grade bonds. Possible discrepancies in the degree of responses
to those shocks are, in fact, relatively limited: the correlation between
the US and global bond indexes since 1990 is high at about 0.9 and
the impulse response results from the model are qualitatively similar and within 25bp of the response on US bond aggregates for
the same sample periods. This reflects the large share of US bonds
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in these global aggregates and high correlations of mature markets

bond yields.
For emerging market bonds, we use the JP Morgan Emerging Market Bond Index Plus (EMBI+) and the JP Morgan Emerging Local
Markets Index Plus (ELMI+), each starting from December 1993. The
difference between the two indexes is that the first includes only US
dollar denominated issues (across the yield curve), while the latter tracks money market instruments (up to three-month maturity)
denominated in each countrys local currency. The two indexes also
have different country weights.
As for equities, our focus is global, given the abundance of reliable return data stretching back to the 1970s, and the international
approach to equity investing by many institutional investors. In
addition to the aggregate MSCI World Index (starting in January
1970),7 we analyse each of the 10 Global Industry Classification Standard (GICS) sectors, as well as growth and value stocks indexes,
tracked through DataStream, and MSCI (GSCI sector indexes start
in January 1973; growth and value indexes start in December 1974).
For emerging market equities, we use the MSCI Emerging Market
Index, beginning in December 1987; finally, for commodities, we use
the S&P Goldman Sachs total return index. The performance of the
latter starts from January 1970 and includes spot price returns, as
well as the return from rolling over futures positions and investing
collateral. A summary of the data is provided in Table 14.1, for the
maximum sample period available in each case. This table confirms
many well-known stylised facts about our asset return data, including that equities are more volatile than bonds (see the standard
deviation column in Table 14.1), risk asset returns are in general
negatively skewed (see the skew column in Table 14.1) and asset
returns follow a random walk (as shown by the unit root tests that
indicate the probability of a non-stationary trend is very high for the
series in levels and very low in first differences).
IMPULSE RESPONSE FOR CORE ASSET CLASSES
Our first set of results compares the impulse response of our five core
variables (CPI and four core asset classes, ie, US cash, US aggregate
bonds, developed market equities and commodities) following a 1%
shock to the monthly CPI at t = 0. Three six-dimensional VAR models are estimated, with the rotating variables being first the EMBI+,
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Table 14.1 Variables: summary statistics (%), January 1970April 2011
US inflation
US T-bill
Bond indexes:
Barclays US
Aggregate
Barclays US MBS
Barclays US Treasury
Merrill Lynch/BoA
Corporate Master
JP Morgan EMBI+
JP Morgan ELMI+
MSCI equity indexes:
World
World value
World growth
Energy
Materials
Industrials
Consumer
discretionary
Consumer staples
Health care
Financials
IT
Telecoms
Utilities
GSCI Commodity
Total Return Index
MSCI Emerging
Markets
Unit root test

p-value

log
log
Skew level change
Mean Max. Min.
SD
0.4
0.5
1.8 1.8
1.3
0.0
1.2
0.9
0.0
0.4
0.06
0.10
0.15
0.28
0.7
10.8 6.3
5.6
0.5
0.58
0.00
0.7
0.7
0.7
14.5 7.9
9.2 5.1
11.3 7.7
6.6
5.5
6.9
0.9
0.3
0.0
0.81
0.43
0.76
0.00
0.00
0.00
0.8
0.7
10.2 33.9 15.3 2.8

7.6 9.1 7.0 0.7
0.90
0.95
0.00
0.00
0.8
1.0
0.8
1.0
0.8
0.8
0.7
13.7 21.0
14.4 20.5
14.0 21.5
16.6 23.4
16.9 31.0
15.6 24.7
17.2 19.5
15.1
14.9
15.9
18.3
19.5
17.2
17.1
0.8
0.8
0.7
0.4
0.8
1.0
0.6
0.72
0.45
0.61
0.93
0.89
0.80
0.84
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.8
0.9
0.8
0.7
0.8
0.9
0.8
16.3 19.5
19.0 18.7
20.9 29.8
21.4 31.2
26.8 17.3
22.5 14.3
22.9 33.1
14.9
14.6
19.7
22.7
17.5
14.5
19.9
0.7
0.4
0.6
0.6
0.1
0.0
0.4
0.93
0.86
0.68
0.83
0.65
0.80
0.26
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.8
32.9 24.0 20.5
0.5
0.21
0.00
SD denotes standard deviation. We use the difference of the logs of each

index multiplied by 100 (eg, for US inflation, the average monthly return,
continuously compounded, is 0.4% in our sample). Sample periods differ
by asset class and sector, depending on data availability.
Source: Thomson Datastream and authors estimates.8
then the ELMI+ and finally the MSCI Emerging Market Equity Index.
The impulse responses of the core variables from these three models
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Table 14.2 Impulse response to a 1% shock to US CPI (%)
Inflation
Cash
Bonds
Equities
Commodities
6 months
12 months
2 years
Long run
1.65
(0.33)
0.01
(0.20)
0.97
(0.04)
1.65
(0.17)
5.59
(0.51)
1.70
(0.49)
0.15
(0.43)
1.13
(0.28)
2.38
(0.60)
4.24
(1.03)
1.94
(1.81)
0.58
(0.56)
0.96
(0.57)
2.64
(1.85)
3.56
(2.06)
2.17
(1.01)
1.45
(1.11)
0.03
(1.07)
2.20
(3.35)
3.65
(3.96)
Bootstrapped standard errors are given in parentheses. The data represents cumulative total log change for the CPI, and cumulative total rate of
return for the four core asset classes.
are the average from each of the separately estimated models, which
tended to be qualitatively similar.
Table 14.2 shows the results, specifically the cumulative total
change for the CPI, and the cumulative total rate of return for the four
core asset classes. For illustration, four time horizons (six months,
one year, two years and ten years (labelled as long run)) are shown
in the table.
US inflation: shocks persist
As expected, US inflation exhibits strong autoregressive properties.
In fact, an initial month-on-month shock of 1% to the CPI causes
an increase in subsequent months, with an effect felt long in the
future. After one year, the cumulative increase in CPI is 70% higher
than the initial annualised shock. Over a 10-year horizon, consumer
prices have risen a cumulative 2.17%, ie, more than twice the initial
shock.
US cash: a far-from-perfect inflation hedge
As a proxy for US dollar denominated cash, we use three-month US
Treasury bills. Given that the short-end of the yield curve is most
directly affected by monetary policy actions, cash returns should
increase in response to an inflation surprise, if there is an expectation
of tighter monetary policy. However, as shown in Table 14.2 and
Figure 14.1, the response is gradual, and the hedge is far from perfect.
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One year from the shock, consumer prices have increased by 1.70%
(see the 12-month column in Table 14.2), while cash returns are
only 0.15%. In the long run, the cumulative return from cash reaches
1.45% (see the long run column in Table 14.2), but still does not
compensate for the loss in purchasing power up to that point (2.17%).
US aggregate bonds: negative real returns
The inverse relationship between US nominal bonds (measured by
the Barclay US Aggregate Bond Index) and US inflation is clear, as the
purchasing power of fixed nominal coupons and notional payments
naturally diminishes with rising inflation. Indeed, following an inflation shock, bonds underperform in comparison to cash. Among the
securities in the aggregate index, long-duration bonds are obviously
the worst performing (due to their long duration). Six months after
the initial consumer prices shock, cumulative inflation has reached
1.65% (see the 6-month column in Table 14.2), while the US aggregate bond index has lost 0.97% (ie, a 2.62% real return). There is
limited recovery over time: at year 10, the US Aggregate Bond Index
reaches a flat cumulative nominal return, but its real return remains
deep in negative territory (2.14%).
In the next section, we analyse the impulse response function
of other inflation-hedging alternatives; specifically, instead of an
aggregate bond index, we consider sector indexes (US treasuries, US
mortgage-backed securities and US corporate bonds) and compare
their performance following an initial consumer prices shock.
Developed markets equities: the worst performing core asset
class hedge
Developed market equity returns (both nominal and real) are deep
in negative territory for all time horizons considered. In the long
run, nominal returns are 2.20% (long run column in Table 14.2),
while inflation-adjusted real returns are 4.37%. These findings are
in line with our earlier work (Atti and Roache 2009), and add further
evidence to other empirical observations, which have questioned the
theoretical underpinnings of equities as an inflation hedge (because
of their real asset characteristics).
In the next section, we shall extend the impulse response analysis
to non-core asset classes, and consider the inflation-hedging performance of the 10 GSCI equity sectors (Table 14.1), value versus growth
equity strategies, and emerging market equities.
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Commodities: the best performing core asset class hedge

Table 14.2 shows that commodities are the best performing asset class
following a shock in US consumer prices. In previous work (Atti
and Roache 2009), we found that the inflation-hedging properties of
commodities diminished over time, but, in this study, commodities
hold on to most of the gains made during the initial stages after
the inflation shock. Differences in these findings reflect the nature
of the commodity index used (ie, the more energy-focused GSCI in
this chapter versus the more balanced Thomson Reuters/Jefferies
CRB Index, which grants a larger share to the agricultural sector in
our previous work). Another source of difference is the fact that a
total return index is selected in this study (which includes the price
return, the return from collateral and the return from rolling futures
contracts forward), as opposed to the simple change in spot prices
used in our previous work.
IMPULSE RESPONSE BEYOND BROAD ASSET CLASSES
Following the analysis of asset classes at the aggregate level, we
analyse the impulse response at a more disaggregated level, ie, the
rotating variables in our VAR models (a total of 17). Specifically,
we shall consider the inflation-hedging performance of
two US bond sector indexes: mortgage-backed securities, and
corporates (two VAR models),

ten GICS global sector indexes of developed markets equities
(ten VAR models),

two developed global market equities style indexes (value and
growth, two VAR models),

two emerging markets bond indexes, one including US dollar
denominated securities only (EMBI+) and the other in money

market instruments denominated in local currency (ELMI+)
(two VAR models),
one emerging market equities index (one VAR model).
Illustrative graphs of the impulse response function of some of

the variables are shown in Figure 14.1.
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Figure 14.1 Percentage response (vertical axis) of asset classes to a

1% shock to US CPI
(a)
2.0
1.6
1.2
0.8
0.4
0
2.5
2.0
1.5
1.0
0.5
0
0 1 2 3 4 5 6 7 8 9 10
(c)
1.0
(b)
0 1 2 3 4 5 6 7 8 9 10
(d)
Treasuries
0
1.0
2.0
1.0
MBS
Corporates
2.0
3.0
0 1 2 3 4 5 6 7 8 9 10
(e)
4
2
0
2
2
6
Energy
Utilities
0 1 2 3 4 5 6 7 8 9 10
Years
6
5
4
3
2
1
0
0 1 2 3 4 5 6 7 8 9 10
(f)
0 1 2 3 4 5 6 7 8 9 10
Years
(a) Inflation; (b) US three-month T-bills; (c) US bonds; (d) MSCI World Equity Index;
(e) MSCI world equity sector indexes; (f) S&P GSCI.
US bond sector indexes

To examine the impulse responses of different bond investments
such as US mortgage-backed securities and US corporate bonds,
both of which are likely to be included in the toolset of many institutional investors, we replaced the US aggregate bond index with
US Treasuries as our core bond index (in the sense that Treasuries
affects equities and other bonds, such as mortgage-backed securities, during the same month, but not vice versa). Then, to study the
impulse response function of Mortgage-Backed Securities and Corporate Bonds, we estimate two VAR models. In the first, the variables
used are indexes for Treasury bills, Treasury bonds, developed market equities, US mortgage-backed securities, commodities and the
CPI. In the second model, the Barclay US MBS Index is substituted
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Table 14.3 US bonds: impulse response to a 1% shock to US CPI (%)
US Treasuries
US MBS
US Corporates
6 months
12 months
2 years
Long run
0.59
(0.05)
1.13
(0.15)
1.80
(0.21)
0.41
(0.11)
1.08
(0.36)
1.90
(0.41)
0.23
(0.22)
1.08
(0.72)
1.96
(0.82)
0.05
(0.42)
0.72
(1.34)
2.26
(1.44)
Bootstrapped standard errors are given in parentheses.
with the Merrill Lynch US Corporate Master Index. The results are
shown in Table 14.3.
As can be seen in Table 14.3, mortgage-backed securities and corporate bonds underperform Treasuries following an inflation shock.
The impulse response for Treasury performance is taken from the
mortgage-backed securities model (the results for Treasuries from
both models, including the standard errors, were almost identical).
In the case of mortgages, their negative convexity makes mortgage-backed securities particularly sensitive to rising real yields. As
homeowners are less likely to prepay, the value of the embedded
optionality in mortgage-backed securities decreases and lengthens
the residual duration of the bond. In the case of corporate bonds, performance is affected in a similar fashion to the case of traded equities:
higher real yields weigh on firms borrowing costs and future overall
profitability.
Over the long run, once the effect of the shock is fully priced in by
investors, Treasuries recover with the help of higher coupons (and
current yields). However, as seen in Figure 14.1, their real cumulative
return remains negative, owing to large early losses that are never
fully recouped.
Developed market equities: sector indexes
After analysing the aggregate global equity index in the previous
section, here we look at the inflation-hedging performance of the
10 traditional Global Industry Classification Standard (GICS) sectors
distinguished by MSCI (Table 14.1).
We estimate 10 different six-variable VAR models with US CPI,
US cash, US bonds, global equities and commodities as the fixed
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Table 14.4 Global equity sectors: response to a 1% shock to US

CPI (%)
Energy
Materials
Industrials
Consumer
discretionary
Consumer
staples
Health care
Financials
IT
Telecoms
Utilities
6 months
12 months
2 years
Long run
3.14
(0.51)
2.26
(0.67)
2.78
(0.57)
3.40
(0.51)
3.70
(0.36)
2.42
(0.46)
0.05
(0.67)
2.52
(0.67)
3.09
(0.62)
5.25
(0.51)
1.03
(1.08)
2.73
(1.34)
2.62
(1.18)
4.22
(1.03)
3.86
(0.77)
2.73
(0.93)
1.44
(1.39)
3.70
(1.39)
3.09
(1.23)
4.94
(1.03)
0.10
(2.16)
3.24
(2.73)
2.47
(2.37)
4.48
(2.11)
4.01
(1.60)
2.57
(1.85)
1.90
(2.83)
3.91
(2.83)
3.04
(2.47)
4.58
(2.06)
0.93
(3.76)
4.68
(4.89)
3.19
(4.27)
4.89
(3.81)
4.22
(2.88)
1.13
(3.60)
1.96
(5.15)
4.01
(5.15)
3.09
(4.42)
4.12
(3.96)
variables, and each of the 10 GICS sectors rotating in and out of the
model in turn.
The first key finding is that the poor performance of developed
markets equities following an inflation shock is broadly spread
across sectors, and occurs rapidly (Table 14.4). Out of the 10 traditional GICS sectors, 9 register a negative impulse response at every
time period following the shock. This adverse effect on returns follows very quickly after the initial shock. For example, total returns
for the Industrials sector are 2.78% six months after the initial
inflation shock, and remain negative thereafter. A similar profile is
evident for most other global equities sectors.
The second key result is that there is noticeable difference in
performance across sectors. Unsurprisingly, following an inflation
shock, the energy sector has positive nominal returns in the short
run, although this effect appears to dissipate over time.
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This partly reflects the important role that oil prices play in inflation shocks, and underscores the importance of understanding the
underlying cause of higher inflation. However, the materials sector,
which includes mining companies, fails to offer similar short-run
inflation protection. This may change, as commodity prices have
become more positively correlated with oil prices. Perhaps surprisingly, financials have tended to perform relatively well in the aftermath of inflation shocks (Table 14.4), although high standard errors
indicate that this is not a particularly robust result. In the short run,
the worst performer is the utilities sector, which underperforms significantly in the first year following the shock. Again, this may reflect
the nature of the shock, as utilities use inputs whose prices are closely
linked to those of crude oil, including coal and natural gas. It is also
due to the frequently regulated nature of pricing which often prevents higher input costs from being passed to consumers, thus negatively impacting profitability. Furthermore, leverage might play a
part, as utilities often have high levels of debt, reflecting the relatively more stable nature of their business. Firms in sectors with less
stable revenues and profits cannot achieve comparable leverage in
the market as they are perceived as more risky. Clearly, an increase in
interest rates and debt servicing costs has a negative impact on their
overall profitability. In the long run, all equities sectors post negative nominal, and inflation-adjusted, returns, with materials and
consumer discretionary being the worst performing indexes.
Developed market equities: growth versus value styles
We next assessed the inflation-hedging features of global equities
across different investment styles (Table 14.5). Again, our two sixvariable models consisted of five core variables (US inflation, US
cash, US bonds, developed market equities, commodities), with one
model including as our rotating variable a global equity growth style
index, and the other a global equity value style index.
Albeit with a large standard error, results show that, following
an inflation shock, growth stocks perform worse than value stocks
(Table 14.5). One reason for this could be that growth stocks are long
duration, with a larger portion of the dividend stream occurring
further in the future. Therefore, they are more sensitive to a rise
in inflation, and consequent high interest rates, than value stocks,
which typically offer a higher current dividend yield.
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Table 14.5 Global equity styles: response to a 1% shock to US CPI (%)

6 months
12 months
2 years
Long run
MSCI World growth
2.21
(0.51)
2.93
(1.08)
3.24
(2.16)
3.45
(3.81)
MSCI World value
1.80
(0.46)
2.21
(0.98)
2.32
(1.96)
2.47
(3.45)
Bootstrapped standard errors in parentheses.
Table 14.6 Global investments: response to a 1% shock to US CPI (%)

6 months
12 months
2 years
Long run
EM bonds (EMBI+)
3.50
(0.36)
3.76
(0.77)
1.65
(1.60)
2.11
(2.78)
EM bonds (ELMI+)
1.97
(0.27)
1.65
(0.77)
1.40
(0.56)
4.01
(1.60)
2.90
(1.14)
2.98
(3.29)
3.01
(1.99)
1.23
(5.92)
Emerging market
equities
Emerging markets: money markets, bonds and equities

From a US dollar-based investors perspective, diversifying away
from domestic markets could help hedge all, or part, of a US inflation
surprise. In the event of a global inflation shock, however, global
diversification might be less effective.
We specifically analysed dollar and local currency emerging market bonds, and emerging market equities. Due to data availability,
our model uses data starting in January 1993 for emerging market
bonds and January 1987 for emerging market equities. These results
are presented separately in Table 14.6 because a direct comparison
with the earlier results (Tables 14.314.5) is made difficult by the different sample sizes; in particular, both the nature of inflation shocks
and the response of broad financial asset classes may have changed
over time.
Although results bear large standard errors, it appears that
regional diversification into local currency emerging market bonds
could represent a useful hedge for a US investor confronted with a
domestic inflation shock. Six months following the shock, the return
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of local currency emerging market bonds (ELMI+ index) is almost

2% (see the 6-month column in Table 14.6), and positive nominal
(and real) returns persist over the long run as well (see the long run
column in Table 14.6). It is worth noting that differences in the modified duration of bond indexes influence some results (for example,
the ELMI+ is a money market index); however, while Treasuries are
characterised by a higher duration than mortgage-backed securities,
they still record a better performance.
INVESTMENT IMPLICATIONS: DYNAMIC ASSET AND SECTOR
ROTATION
For long-term investors with conviction in their views about the
future path of inflation, these results have major implications. This
is particularly true for non-consensus views in which investors
may expect positive inflation surprises, and are willing to reposition
their portfolio ahead of the shock.
Our results show that it is difficult for a static long-term strategic asset allocation to protect a portfolio against unexpected inflation using traditional asset classes. However, it might be possible to
achieve some degree of inflation protection through tactical asset
allocation, and sector rotation within each broad asset class. For
example, in anticipation of an inflation shock, investors could tilt
the portfolio towards commodities and away from bonds, and then
progressively start to rebalance after 1218 months. For bond-only
investors, the key is to overweight Treasuries. This is because an
inflation surprise has typically led to higher short-term interest rates
and reduced expectations for economic and profit growth, which has
an adverse effect on credit sectors. Government bonds sector indexes
outperform credit-spread products and mortgage-backed securities
following inflation shocks. Notwithstanding these differences, all US
dollar denominated fixed-income instruments, including US cash at
the short-end of the yield curve, post negative real returns in the
long run.
As for equities, our results suggest that for investors who do not
take tactical portfolio positions, the rationale for holding equities
should be based on a very long-term horizon to ensure that the effects
of inflation cycles average out. After all, historical evidence shows
that equities outperform (safer) government bonds over very long
periods of time (Dimson et al 2011). However, equities do not appear
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Figure 14.2 Passive versus dynamically rebalanced diversified

portfolios
Equally weighted top five
inflation hedgers
Benchmark
130
Portfolio performance
125
Second
rebalancing
120
Back to
neutral
115
110
105
First
rebalancing
100
95
90
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Number of months
The vertical axis shows the portfolio index value, which starts at 100.
to offer much protection against unanticipated inflation, a result that

is robust across developed markets sectors and styles, and emerging
markets as well. To a large extent, this is likely to be due to the effect of
higher interest rates reducing the present value of future dividends
(equities are a long-duration asset), and also depressing expectations
of economic and dividend growth. Investors with the scope to tilt
their portfolios could underweight certain industry sectors, notably
utilities, and overweight those that are the most likely to benefit
from rising prices, namely the energy sector. Furthermore, from an
equity-style perspective, value outperforms growth, and aggregate
emerging market equities outperform the developed market index.
Although both developed and emerging market equities and
bonds do not provide adequate protection from an inflation shock,
international portfolio diversification can still be valuable. In particular, holding short-duration emerging market assets denominated
in local currency, which are less correlated to US price movements,
provides a valuable hedge in our data sample.
Historically, our global aggregate commodities index records the
best performance following a US inflation shock. Indeed, commodities, together with the ELMI+, are the only asset classes posting
positive real, ie, inflation-adjusted, return in the long run.
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For illustrative purposes, we backtested the findings of this

chapter by constructing a rules-based in-sample portfolio. Perfect
investor foresight is assumed in each of the five largest US inflation shocks estimated by the VAR model in the period since 1970
(these shocks occurred in 1977, 1981, 1982, 1993 and 2001), which
means that the investor adequately tilts their portfolio just before
the release of a higher-than-expected CPI reading. Against a benchmark portfolio allocated to domestic and global bonds (40% weight),
developed and emerging markets equities (50%) and commodities (10%), a sample active portfolio is rebalanced such that it is
equally invested in the top five best performing inflation-hedging
assets in year 1, and it is then rebalanced again to hold the best
five inflation hedgers in year 2, before going back to the benchmark
(Figure 14.2).
This means that the portfolio would, for example, hold commodities and energy stocks in year 1, then reallocate to utilities and emerging market equities in year 2, as the hedge properties of some of the
best performing assets at the onset of a shock begin to diminish.
Although it is obvious that other important factors besides inflation
expectations are driving asset returns, the use of a dynamic asset
and sector rotation strategy in periods of elevated inflation pressures
generates superior in-sample performance, while keeping volatility
broadly unchanged. In fact, annualised returns are about 1% higher
after three years, or about 3% higher cumulatively.
Of course, one important aspect not considered here is the nature
of the inflation shock. Cost-push inflation (eg, from an oil supply
shock) has different effects from demand-pull inflation, and the
geographical spread of the shock, including whether it is countryspecific or global, is important as well. In general, cost-push inflation
tends to be more transient, caused by volatile commodity prices, for
example. Demand-pull inflation instead might be the result of more
persistent price changes, such as rising wages and rising demand in
general, and thus drive both headline and core inflation higher.
Clearly, these considerations have implications for the response
of policymakers. In the cost-push case, central banks with sufficient credibility and a well-understood (even if implicit) inflationtargeting regime may absorb the temporary rise in headline inflation
without resorting to monetary action and rising short-term interest
rates. This would suggest that cash underperforms both bonds and
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equities. In this case, commodity investments would tend to do well,

given the nature of the shock. In contrast, demand-pull inflation is
likely to elicit a more aggressive response by central banks, resulting
in higher (short-term) interest rates. Depending on whether or not
their response is deemed adequate by markets, this might tend to
favour cash over bonds, with equities likely to perform poorly in
anticipation of a policy-induced economic slowdown.
CONCLUSIONS
This chapter explored the long-run dynamics of different assets following a US inflation shock. We were able to identify the most effective inflation hedges, going beyond broad asset classes, and looking into a range of US domestic and international fixed-income and
equity sectors.
Our first set of results compared the impulse response of our five
core variables (CPI and four core asset classes, ie, US cash, US aggregate bonds, developed market equities, and commodities) following
a 1% shock to the monthly CPI. As expected, US inflation exhibited strong autoregressive properties; commodities were the best
performing class, while equities underperformed.
Following the analysis of asset classes at the aggregate level, we
analysed the impulse response at a more disaggregated level, detailing our results along the way. Hedge performance was analysed at
different time horizons, in order to gain insight into possible active
asset allocation/sector rotation strategies.
What are the practical implications of these findings? First, traditional broad asset classes provide an imperfect inflation hedge,
at best, and in some important cases, including equities, do very
poorly. But, for long-term long-only investors, there is still hope.
In particular, for those with confidence in their views about the
path of future inflation, there is scope to enhance inflation protection through tactical asset allocation and sector rotation within each
asset class. Even within equities, there is broad divergence across
sectors in their inflation-hedging properties. Similar divergence is
evident within the bond universe. In summary, investors need to
look beyond broad asset classes and be willing to take sectoral bets
to ensure optimal inflation protection.
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The Taylor Rule, which is a descriptive model of how the US Federal Reserve have been
setting the funds rate since the early 1990s, empirically contradicts this, as a 1% change in
inflation translates into a higher percentage change in the short-term rate.
Granger and Newbold (1974) and Johansen (1991) are the seminal papers describing these
statistical techniques.
The hypothesis that the first differences follow a unit root process can be rejected at the 5%
level for all variables, except for the Treasury bill total return index, for which rejection is
possible only at the 10% level.
See Atti and Roache (2009) for further details on model specifications.
Bailey (1992) lists six qualities of a valid benchmark: unambiguous, investable, measurable,
appropriate, reflective of current investment opinions and specified in advance.
See http://www.globalfinancialdata.com.
See http://www.msci.com.
See http://online.thomsonreuters.com/datastream/ and http://www.crbtrader.com/.
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Ang, A., M. Brire and O. Signori, 2011, Inflation and Individual Equities, URL: http://
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Atti, A., and S. Roache, 2009, Inflation Hedging for Long-Term Investors, IMF Working
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Bailey, J. V., 1992, Are Manager Universes Acceptable Performance Benchmarks?,
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Balduzzi, E., and C. Green, 2001, Economic News and Bond Prices: Evidence from the
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Bekaert, G., and X. Wang, 2010, Inflation Risk and the Inflation Risk Premium, Economic
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Bodie, Z., 1976, Common Stocks as a Hedge against Inflation, The Journal of Finance
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Brire, M., and O. Signori, 2010, Inflation-Hedging Portfolios in Different Regimes,
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Buckland, R., 2008, The Inflation Threat, Citi Global Equity Strategist, July 5.
Dimson, E., P. Marsh and M. Staunton, 2011, Credit Suisse Global Investment Returns
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Evans, M. D. D., 1998, Real Rates, Expected Inflation, and Inflation Risk Premia, The
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Fisher, I., 1930, The Theory of Interest (New York: Macmillan).
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Futures, Financial Analysts Journal 62(2), pp. 4768.
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Granger, C. W. J., and P. Newbold, 1974, Spurious Regression in Econometrics, Journal

of Econometrics 2, pp. 11120.
Jaffe, J. F., and G. Mandelker, 1976, The Fisher Effect for Risky Assets: An Empirical
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Johansen, S., 1991, Estimation and Hypothesis Testing of Cointegration Vectors in
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Mundell, R. A., 1963, Inflation and Real Interest, Journal of Political Economy 71(3),
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Solnik, B., 1983, The Relation between Stock Prices and Inflationary Expectations: The
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Strongin, S., and M. Petsch, 1997, Protecting a Portfolio against Inflation Risk, Investment
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Part III
Practical Insights from

Market Participants
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15
Practical Models for

Inflation Forecasting
Nic Johnson
PIMCO
There are many different schools of thought as to what causes inflation, and over the years many explanations have been put forward to explain historically observed inflation dynamics. There are
monetarists, who believe that changes in-the-money supply are the
most important inflationary dynamic, while Keynesian economists
argue that underlying pressures in the economy play a large role in
determining inflation levels.
In this chapter, we shall not delve into the academic and philosophical issues surrounding inflation but instead focus on the
forecasting methods used by practitioners, including top-down,
bottom-up and time-series-based models. We shall look at the appropriateness of different frameworks, depending on the type of data
inputs available, as well as the frequency and length of forecast
desired. Finally, we shall consider some of the differences involved
with modelling inflation in the US, and other developed global
markets, relative to emerging markets.
FUNDAMENTAL TOP-DOWN MODELS FOR FORECASTING
INFLATION
The goal of a top-down macro inflation model is to identify economic variables that are leading indicators of changes in the price
of various goods and services. From these leading indicators, an
investor will be able to better predict both the direction and the
magnitude of changes in the rate of inflation. Top-down models are
mostly used for analysing core inflation, since the prices of food and
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Year-over-year core inflation (%)
Figure 15.1 Unemployment and core inflation

16
19972010
19851993
19751984
14
12
10
8
6
4
2
0
0
4
6
8
Unemployment rate (%; lagged 1 yr)
10
12
197584: y = 1.4774x + 0.1883, R2 = 0.6428; 198593: y = 0.4866x + 0.0742,

R2 = 0.5164; 19972010: y = 0.3549x + 0.0396, R2 = 0.4793.
Source: data from PIMCO, Bloomberg and BLS.
energy are often driven by exogenous shocks (geopolitical, weather

related, etc), which are difficult to forecast within such a model.
In the next section, we discuss how food and energy inflation can
be modelled using a bottom-up approach, thereby allowing a topdown core inflation forecast to be extended to a forecast of headline
inflation.
Top-down macroeconomic models typically rely on a relation
between inflation and the unemployment rate, or the output gap,
plus information on money supply and inflation expectations. The
benefits of using a top-down framework are that the model tends to
be quite tractable and not overly data intensive. In addition, a long
forecasting horizon of the order of 13 years is typically possible.
A theoretical framework should guide the process of identifying
leading indicators. For example, one such framework might be based
on supplydemand equilibrium. When a good is in short supply,
its price must rise in order to encourage incremental production
and reduce demand. Similarly, when a good is plentiful, its price
is likely to fall in order to discourage incremental production and
increase demand. Thus, forecasting inflation within such a framework requires the identification of factors that will drive the relative
supplydemand balance for a large variety of goods.
The unemployment rate is one macroeconomic variable that both
affects and reflects the supply and demand dynamics of many
goods and services. Intuitively, the unemployment rate should be
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PRACTICAL MODELS FOR INFLATION FORECASTING
positively correlated with the general availability of labour, for either

services or the manufacturing of goods. Since labour represents a
dominant portion of the cost and availability of many goods and
services, the unemployment rate is a good proxy for the availability
of supply of many goods and services. In addition to the information
provided about the supply of goods and services, the unemployment rate also has implications for the demand for goods and services, since high levels of unemployment coincide with lower levels
of consumption. This inverse relationship between the unemployment rate and inflation was first discovered by Irving Fisher (1926),
and later formalised by William Phillips (1958), through what has
become known as the Phillips curve. The inverse relation between
inflation and unemployment is shown in Figure 15.1.
The inverse relationship between inflation and unemployment
becomes much clearer if the historic data is broken down into different periods of time, as done in Figure 15.1. The primary reason for
this is that the level of inflation expectations changed over the period
from 1975 to 2010. Inflation expectations anchor the overall prevailing level of inflation in an economy and they form the baseline or
reference point around which relationships like that between unemployment and inflation operate. For example, we expect to see an
increase in inflation when the unemployment rate declines, but an
increase relative to what level? The expected increase in inflation is
relative to the level of inflation expectations. This is why separating
the data into periods with similar inflation expectations allows us to
better isolate the impact of unemployment. In contrast, if the complete period is used, the relationship between unemployment and
inflation is completely obscured by the decline in inflation expectations. Because of this, controlling for the impact of inflation expectations is crucial when developing both top-down and bottom-up
inflation models.
It should be noted that unemployment is just one measure of overall economic activity, and much work has been done on looking at
the relation between inflation and other measures of economic activity. In particular, studies have shown that a Phillips-type curve can
be reproduced using several other macroeconomic variables, including housing starts, inventory levels and capacity utilisation (Stock
and Watson 1999). In particular, the Chicago Fed National Activity Index (CFNAI) is an aggregate of several economic indicators,
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Figure 15.2 Chicago Fed National Activity Index and core inflation
(19972010)
3.0
2.5
2.0
1.5
1.0
0.5
0
3.0
2.5
2.0
1.5
1.0
0.5
0.5
1.0
CFNAI (12-month MA; lagged 18 months)

Source: data from PIMCO, Bloomberg, Federal Reserve Bank of Chicago and
BLS.
selected because of their relation to aggregate economic activity and

inflation. Historically, the CFNAI, like the unemployment rate, has
had a strong correlation with future levels of inflation, as shown in
Figure 15.2. Incorporating multiple variables into a Phillips curve
framework improves the robustness of an inflation model by more
fully capturing aggregate economic activity and the output gap, and
hence better forecasting inflationary pressures. However, care must
be taken not to over fit the data. Conducting analysis on the stability
of relationships across multiple slices of history is one way to avoid
such a pitfall.
In addition to unemployment and measures of aggregate economic demand, the money supply is another macroeconomic factor
with a strong theoretical link to inflation. Assuming constant velocity, if the money in circulation increases more than the real value of
goods available for purchase, then the nominal value of those goods
will rise, resulting in inflation. As the monetarist economist Milton
Friedman stated: Inflation is always and everywhere a monetary
phenomenon (Friedman 1963). However, the relationship between
inflation and money supply is more difficult to observe in the data.
One of the reasons for this difficulty is that the velocity of money
is not constant. Another confounding factor is that, historically, the
money supply has had a long leading relationship to changes in
the rate of inflation. While this should provide for a long-horizon
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Figure 15.3 Money supply and core inflation

16
19972010
19841996
19741983
14
12
10
8
6
4
2
0
4
6
8
10
12
14
Year-over-year change M2 (%; lagged 3 years)
16
197483: y = 0.582x + 0.0252, R2 = 0.3403; 198496: y = 0.1669x + 0.0288,

R2 = 0.4106; 19972010: y = 0.009x + 0.0213, R2 = 0.0013.
Source: data from PIMCO, Bloomberg, Federal Reserve Bank and BLS.
forecast, it also means that the relationship between money supply

and inflation can be clouded by a great deal of noise introduced by
either a change in money velocity or other non-monetary factors.
Hence, although large changes in money supply should eventually
have a visible impact on inflation, smaller changes in-the-money
supply will often be dwarfed by other factors. Furthermore, the benefit of a long leadlag relationship comes at the expense of diminished
forecasting accuracy. Historically, changes in-the-money supply led
changes in inflation by an average of three years, but the sensitivity
of inflation rates to a change in money supply declined in the latter
part of the 20th century, just as was observed in the case of inflation
and unemployment. In fact, between 1997 and 2010 the correlation
between changes in-the-money supply and changes in inflation had
dropped to essentially zero, as shown in Figure 15.3. One reason for
the low correlation between money supply and inflation during this
period is that the velocity of money was not constant, eg, periods
of increasing money supply were associated with declines in the
velocity of money. This does not imply that money supply changes
no longer matter, but it does suggest that models that forecast inflation based on changes in-the-money supply, in isolation from other
factors, should be taken with a pinch of salt.
The relation between inflation and unemployment, or other measures of economic activity, is relatively stable in the short run but,
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periodically, large regime shifts have occurred, as can be seen in

Figures 15.1 and 15.3. Since the 1970s, not only has the overall
rate of inflation moved progressively lower, but the sensitivity of
inflation to unemployment has also declined substantially, making unemployment a less relevant indicator. It is indeed interesting to consider the reasons behind these regime shifts, and what
has caused inflation changes since 2000 to show a decreasing sensitivity to many macroeconomic variables. The factors at play are
of course several. Two important factors are increased central bank
credibility and explicit inflation targeting. In the post-Volcker era,
lower inflation expectations have moved the Phillips curve lower
and to the left (Figure 15.1). Another contributing factor to lower
inflation sensitivity might have been a decrease over time in the
non-accelerating inflation rate of unemployment (NAIRU). Another,
which is often overlooked, is increased globalisation. No longer is it
just the level of unemployment, or the output gap in the US, that
drives domestic inflation. The growth in the size of the Chinese
and other emerging economies, combined with their corresponding
growth in global trade, has meant that it is increasingly global unemployment and the global output gap that drives both US and global
inflation rates. In addition to reducing the sensitivity of domestic
inflation to domestic macroeconomic variables, the lower volatility
of the global output gap has also served to reduce the volatility of
inflation. Because of the decreasing sensitivity of inflation with many
domestic macroeconomic variables, as reflected by the flattening of
the Phillips curve, it is likely that inflation models will soon start
to explicitly incorporate more global-based measures of economic
activity.
Because these top-down macro models have displayed several
regime shifts, in line with the changing fabric of our global economy,
any solid inflation forecasting framework should not dogmatically
rely only on a single methodology. Towards this end, the following
section discusses bottom-up inflation forecasting methods that can
complement the top-down approaches outlined above.
FUNDAMENTAL BOTTOM-UP MODELS FOR FORECASTING
INFLATION
The bottom-up approach to inflation modelling is fundamentally
different from the top-down approach. Instead of looking at a few
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macro variables that have an effect on the aggregate level of inflation,

the bottom-up approach focuses on modelling each of the various
components that make up the consumer price index (CPI), or other
inflation measures. Table 15.1 shows the various sub-indexes that
make up the CPI, along with some examples of leading indicators
for these various sub-indexes.
For example, consider shelter, which has the largest weight in
the CPI. The rental vacancy rate reflects the overall supplydemand
balance in the rental market. In addition, the change in home prices
and mortgage payments is also relevant, because there is a relationship between the costs of owning versus renting a home. Finally, it
may be possible to get direct leading forecasts for rental inflation
by obtaining survey data about landlord intentions for future rent
changes.
After identifying different factors which may have a meaningful (and hopefully stable) relationship to shelter prices, time-series
analysis can be used to quantify the exact nature of that relationship. For example, does the vacancy rate lead shelter inflation, or
is it a concurrent indicator? Is the relationship between a change in
the vacancy rate and the rate of shelter inflation linear? Is it stable
over time? Does it depend on other variables that also affect shelter
inflation? This question can be answered using a time-series analysis
software package, or within a customised spreadsheet model.
Regardless of how the individual components are modelled, it is
important to avoid over-fitting. In fact, it is easy to fit each component of CPI very accurately using the abundant financial and
economic data available. However, the purpose of constructing an
inflation model is not to fit the past, but to predict the future. This
is why it is very important that the inputs are sensible and that reasonableness checks are put in place. For example, it is economically
meaningful that vacancy rates and shelter inflation are negatively
correlated, ie, higher vacancy rates should result in a downward
movement in shelter inflation. Consequently, if shelter inflation is
regressed against several variables, and its sensitivity to vacancy
rates turns out to be positive, this strongly suggests that the model
might be suffering from over-fitting.
An analogous process of collecting multiple data series, testing
different leadlag relationships and selecting the best explanatory
variables must be repeated for each of the components of the CPI.
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Table 15.1 CPI: components and weights
Categories
Weight
(%)
Examples of
leading indicators
Shelter
31.96
Vacancy rates; mortgage

payments; home prices; utility
prices
Food and beverages
14.79
Medical
6.63
Recreation
6.29
New and used cars
5.57
Motor fuel
5.08
Home furnishing
4.41
Household energy
4.00
Apparel
3.60
Communication
3.31
Education
3.11
Prices of grains, meat, milk and

produce
Health insurance premiums;
service sector wages
Import prices; the value of the
dollar; Chinese inflation
Import prices; wholesale used
car prices
Petroleum retail and futures
prices
US dollar; Chinese inflation
Wholesale power prices; natural
gas and coal prices
Cotton prices; import prices;
Chinese inflation
US dollar; Chinese inflation
Service sector wages and
demographic trends
Personal care
2.59
Public transport
1.23
Residual misc. items
7.45
Jet fuel prices
Source: PIMCO and BLS. Data correct as of December 31, 2010.
Given the large number of sub-indexes, and the amount of work

involved with developing models for each one, it is important to
understand which are the components that should be modelled most
carefully, as they influence the accuracy of the final forecast to a
greater degree. One way to assess this is to look at the weight of each
series scaled by its respective volatility. In other words, the weights
in Table 15.1 are multiplied by the standard deviation (estimated
in the 19942010 time window) of the monthly changes for each of
the individual sub-indexes. The results are shown in Table 15.2. The
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Table 15.2 CPI: relative volatility of individual sub-indexes
Sector
Volatility
contribution (%)
Petroleum
Shelter
Household energy
Food
New and used cars
Recreation
Communication
Home furnishing
Public transport
Apparel
Medical
Education
0.98
0.35
0.27
0.17
0.13
0.06
0.06
0.05
0.05
0.04
0.04
0.02
Core
Headline
0.43
1.16
Source: PIMCO and BLS.
overall volatility of headline CPI has been 1.16%, with petroleum

contributing a whopping 0.98%. By contrast, the volatility of the
core components of CPI is 0.43%. The relative volatility contribution
of core CPI is much smaller than for motor fuel, despite the fact
that the core CPI basket comprises over 75% of the weight in the
total CPI, compared to just 5% for motor fuel. Consequently, the
accuracy of any headline CPI forecast critically depends on how well
one can forecast the most volatile components, petroleum prices in
particular.
In the following, we shall discuss how to approach the four
largest volatility weighted contributions to CPI, ie, petroleum, shelter, household energy and food. Besides volatility considerations,
modelling energy (both motor fuel and household components) and
food is also the crucial final step in moving from a top-down macro
core inflation forecast to a forecast of headline inflation.
Petroleum inflation
It is common for investors, possibly lacking a fundamental view
on the underlying supplydemand dynamics, to forecast petroleum
prices in the future1 by using the petroleum futures market since
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this price information is readily available and transparent and represents an actual market price that can be used for hedging. The
spot price of petroleum reflects all of the currently known supply
demand factors, both existing and those expected in the future. The
future prices are linked to the spot price through an arbitrage condition, ie, through the addition of financing and storage costs and
a convenience yield. However, the extent to which the futures price
of petroleum is an accurate or reliable forecast of prices in the future
is questionable, considering that realised and implied volatility are
generally quite high. For example, the typical annual implied volatility of options on petroleum futures is around 3040%, which points
to the intrinsic difficulty in obtaining an accurate forecast at comparable time horizons. Nevertheless, without a fundamental model of
supply and demand, the futures curve remains the common starting
point for petroleum forecasting in the medium to long term.
Forecasting in the very short term, specifically focusing on the
next petroleum inflation number, is actually easier, the reason being
twofold:
1. the inflation index is published at a monthly frequency,
while information on price behaviour is observed at higher
frequency (for example, daily);
2. there is a one-month lag, as the CPI published in month n is a
measure of inflation in month n 1.2
High-frequency price information can come from various sources.
These include daily petroleum futures prices and daily retail market
surveys such as the one conducted by the Automobile Association
of America (AAA). Each of these daily data sources can then be averaged over month n 1 to accurately forecast the upcoming rate of
petroleum inflation. Note, however, that using petroleum futures
prices involves a fair amount of basis risk since the contract represents wholesale petroleum prices with delivery in New York Harbor,
while the petroleum inflation in the CPI is an average of retail prices
across the US. As a result of this basis risk in the petroleum future,
the AAA petroleum price survey is the most accurate way to forecast petroleum inflation in the very short term, since it represents
retail prices from gas stations across the country. Not surprisingly,
the AAA petroleum survey displays an impressive 99% correlation
with the monthly petroleum CPI inflation rate.
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Shelter inflation
After petroleum, the next most important sub-index in the CPI, when
it comes to volatility contribution, is shelter. Shelter has two main
components: the rent of primary residence (about 6% of the CPI)
and the owners equivalent rent of primary residence (OER, about
23% of the CPI). There is a substantial amount of misinformation
about OER, but the main point is that, for both the rent and the
OER components, the US Bureau of Labor Statistics (BLS) uses actual
rather than imputed3 rent data (collected in the CPI Housing Survey)
to calculate inflation rates. Hence, for both components, the main
variable to model is the rate of inflation of the average consumers
rent.
As mentioned before, some of the economic factors that could
be important to forecasting changes in rental rates are those that
describe the supplydemand balance of rentals, and those that compare the relative cost of renting versus buying a home. In addition
to these macro factors, there is also a microeconomic effect that is
important for higher frequency models, namely utility price adjustments. Since most rental rates include some utility payments, if, for
example, the price of water goes up sharply in one month and water
is included in the rent, then the rent is effectively decreased. The
same dynamic is true for other utility prices, such as electricity or
natural gas. The BLS attempts to compensate for these effects. Therefore, when utility prices increase, this places downward pressure on
shelter inflation, and vice versa when utility prices fall. A bottom-up
model can capture these effects by feeding the output of a household
energy and utilities model, discussed in the following section, into
a model for shelter inflation.
Household energy inflation
Household energy consists primarily of retail power prices. A logical
place to start is wholesale power prices, as these are available across
Europe, the US and several other countries. By examining this data, it
is possible to establish the relationship between wholesale and retail
prices, including the relative sensitivity (beta) and the leadlag.
If the lead time from wholesale to retail power prices is shorter
than the time horizon sought for the forecast (say, for example,
wholesale prices have a three-month lead to retail prices, but a
twelve-month forecast of retail prices is desired), then we could look
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Food inflation
Agricultural and Livestock Index
70
60
50
40
30
20
10
0
10
20
30
40
Year-over-year GSCI
Agricultural and Livestock Index (%)
7
6
5
4
3
2
1
0
1
Dec 1991
Dec 1992
Dec 1993
Dec 1994
Dec 1995
Dec 1996
Dec 1997
Dec 1998
Dec 1999
Dec 2000
Dec 2001
Dec 2002
Dec 2003
Dec 2004
Dec 2005
Dec 2006
Dec 2007
Dec 2008
Dec 2009
Dec 2010
Dec 2011
Year-over-year food inflation (%)
Figure 15.4 Food inflation and agricultural and livestock price changes
Source: data from PIMCO, Bloomberg, BLS, Standard & Poors.
for leading indicators of wholesale prices. In this regard, given that

a large portion of US electricity is produced via coal and natural gas,
looking at coal and natural gas prices can be very helpful.
Food inflation
A similar logic can be applied to forecasting retail food prices. In
fact, the processed foods sub-component of the Producer Price Index
(PPI) is essentially a wholesale measure of food prices: it tends to
be highly correlated with retail prices, and changes in wholesale
prices typically lead retail food inflation by an average of one to
two months. Just as in the case of household energy, longer forecasts can be made using supplementary inputs, such as the prices
of corn, wheat, livestock and milk, or a basket like the Agricultural
and Livestock component of the Goldman Sachs Commodity Index
(GSCI). Figure 15.4 shows the year-over-year percentage change in
the GSCI Agricultural and Livestock Index, lagged by eight months,
along with year-over-year food inflation.
Forecasts can also be extended beyond this eight-month lead
period by using the futures curves for the relevant agricultural and
meat commodities, along with fundamental supply and demand
information, such as farmers planting intentions, inventory levels,
etc. Additional refinements can be made by creating a custom basket of food prices with greater breadth, and also by selecting a set of
weights designed to mirror those in the food component of the CPI.
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To summarise, both top-down and bottom-up approaches have

merits and weaknesses, and this is why they complement, rather
than substitute, each other. While both rely on fundamental analysis, the top-down approach focuses on medium- to long-term macroeconomic equilibrium relationships, and it is therefore vulnerable to
regime shifts. In this regard, a bottom-up approach, which typically
relies on shorter-term dynamics, can provide a warning signal of
possible structural breakages.
In addition, while several macro-equilibrium relationships are
intrinsically long-term conditions, a bottom-up model can be customised to cover a variety of shorter term forecasting horizons, thus
providing a bridge between the two approaches. The bottom-up
approach uncovers information about the specific channels that are
driving inflation, be it rising housing prices or a falling US dollar,
and this insight can be crucial for implementing the right investment
strategy.
One drawback of a bottom-up approach is that there are a large
number of moving parts, and an extensive amount of data and analysis is required. With this comes the risk of data over-fitting and under
appreciation of future forecasting errors.
TECHNICAL TIME-SERIES MODELS FOR FORECASTING
INFLATION
The previous modelling approaches involved using fundamental
factors. However, it is also possible to gain significant insights from
technical, or time series, analysis.
For example, many of the sub-indexes that make up the CPI tend
to have a strong trending tendency, with preceding month percentage changes generally being the best guess for next months percentage changes. See Figure 15.5(a) for an illustration of this relationship, using owners equivalent rent. In addition, changes in the
percentage change (ie, the second derivative) of owners equivalent rent tend to be mean reverting, with deviations in the rate of
monthly percentage change often partially reversed in the following month. Figure 15.5(b) shows that an acceleration or deceleration
in the monthly rate of change in the previous month tends to be
partially reversed in the following month.
In other words, if the rate of OER inflation accelerates in month n,
it is likely to decelerate in the following month, n + 1, thus exhibiting
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Figure 15.5 The nature of owners equivalent rent

OER month-over-month current (%)
(a)
y = 0.9421x
0.6
R2 = 0.5448
0.5
0.4
0.3
0.2
0.1
0
0.1
0.2
0.2
0.1
0.1
0.2
0.3
0.4
0.5
0.6
OER month-over-month current minus

OER month-over-month one-month lag (%)
OER month-over-month one-month lag (%)

(b)
0.4
y = 0.5456x
0.3
R2 = 0.3005
0.2
0.1
0
0.1
0.2
0.3
0.3
0.2
0.1
0.1
0.2
0.3
0.4
OER month-over-month one-month lag minus OER MoM two-month lag (%)
(a) Trending nature; (b) mean-reverting nature.
Source: data from PIMCO, Bloomberg and BLS from 2000 to 2011.
mean reversion characteristics. This is common of most other CPI

sub-indexes, with a few exceptions showing the opposite tendency,
ie, persistence (one example is apparel, for which high inflation in
month n is generally followed by high inflation in month n + 1).
In addition to determining if inflation indexes are trending or
mean reverting, time-series analysis should also be used to incorporate the seasonality of inflation. In fact, for some sub-indexes, such
as apparel, the seasonal changes alone can be used to explain most
month-to-month percentage changes. Adjusting for these seasonal
effects is important because it can materially improve the accuracy
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Table 15.3 Developed and emerging market food inflation

Food
weighting
in CPI (%)
Commodity
pass-through
to food CPI (%)
Commodity
pass-through to
headline CPI (%)
US
EU countries
UK
Japan
Canada
Australia
13.7
14.0
9.3
25.9
17.0
15.4
6.2
5.9
15.6
6.0
6.4
2.6
0.8
0.8
1.5
1.6
1.1
0.4
Average
15.9
7.1
1.0
China
Brazil
Mexico
India
Russia
Turkey
33.0
30.2
22.7
47.1
38.0
27.6
25.0
14.7
9.0
16.2
16.2
10.0
8.2
4.4
2.0
7.6
6.1
2.8
Average
33.1
15.2
5.2
Country
Source: PIMCO, BLS, Haver and Bloomberg.
of both bottom-up- and top-down-type models. Furthermore, correctly modelling seasonal factors is important because the returns
that an investor earns from holding US Treasury Inflation-Protected
Securities are linked to the non-seasonally adjusted level of inflation.
To conclude, technical analysis is useful in studying the time series
characteristics of inflation indexes, including seasonality patterns,
and thus it can add to the accuracy of both top-down and bottom-up
inflation models, particularly at higher frequencies.
FORECASTING INFLATION IN DEVELOPED VERSUS
EMERGING MARKETS
Although similar methods and principles can be used to forecast
inflation in both developed and emerging economies, there are some
noteworthy differences.
Emerging markets (EMs) tend to have a much higher food weighting in their consumption baskets, while developed markets (DMs)
tend to have higher weightings of services. Table 15.3 shows the
weightings of food in the CPI basket for a handful of emerging and
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developed market countries. On average, the weight of food in EM

consumption baskets is 33%, roughly twice as large as that seen in
developed countries.
Another difference between developed and emerging markets is
that, in EM, input costs represent a larger share of the price of the
finished goods. For example, in the US, a 1 lb box of cereal might cost
about US$3. The prices of corn and wheat fluctuate widely from year
to year, but from 1991 to 2011 they ranged from 3 /lb to 20 /lb, just
a small fraction of the overall price of the box of cereal. This means
that the sensitivity of inflation rates to changes in input costs in
developed countries, like the US, is relatively low.
For example, the sensitivity of US food inflation to the GSCI Agricultural and Livestock Index has averaged just 6.2% (ie, a 100%
increase in the GSCI Agricultural and Livestock Index would cause
a 6.2% increase in the CPI food sub-index). Therefore, since food
represents roughly 14% of the overall CPI basket, a 100% increase
in the GSCI Agricultural and Livestock Index implies a 0.9% (14%
times 6.2%) increase in the CPI itself.
In contrast, as shown in Table 15.3, the average sensitivity of food
inflation in EM is roughly twice that in DM countries. Combining the
greater sensitivity to input costs (third column in Table 15.3) with the
higher weighting of food in consumption baskets (second column in
Table 15.3) means that a given change in underlying food prices has
on average almost five times the impact on EM inflation compared
with DM inflation (fourth column in Table 15.3).
The previous example highlights the necessity to develop separate
inflation models for individual countries, although it is clear that
several price inputs and macroeconomic variables will be relevant
for all.
CONCLUSIONS
In this chapter we looked at multiple approaches to modelling inflation, including fundamental top-down and bottom-up models, as
well as technical time-series analysis. Clearly, each approach has
benefits and drawbacks.
Typically, the top-down approach has the longest forecasting horizon, but relative to a bottom-up approach it tends to have less accuracy in the short term. In countries like the US where financial and
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economic data are plentiful, a bottom-up inflation model can complement a top-down approach, increase short-term accuracy and
give early warning of structural shifts in the underlying inflation
dynamics. In practice, building such a model can prove more challenging for emerging economies, where available data might be
relatively sparse.
1
Commodity spot and future prices typically exhibit strong seasonality (because either demand
or supply is seasonal). The forward price at time t for delivery at T, F(t, T ), inherits the
seasonality of the underlying spot price P (t) at time t. Consequently, to extract a forecast of
future price at time T, we need to adjust for seasonality effects.
Of course, we have to bear in mind that market prices also adjust to the same high-frequency
information, so this inflation forecast is likely to be of limited use in trading ahead of the
curve.
Part of the confusion arises because the relative weight of OER in the CPI (about 23%) is
calculated from imputed expenditures, derived from asking a sample of homeowners the
question: If someone were to rent your home today, how much do you think it would rent
for monthly, unfurnished and without utilities?.
REFERENCES
Fisher, I., 1926, A Statistical Relation between Unemployment and Price Charges, International Labour Review 13(6), pp. 78592. (Reprinted as I Discovered the Phillips Curve:
A Statistical Relation between Unemployment and Price Changes , Journal of Political
Economy 81(2), pp. 496502 (1973).)
Friedman, M., 1963, Inflation: Causes and Consequences (New York: Asia Publishing House).
Stock, J., and M. Watson, 1999, Forecasting Inflation, Journal of Monetary Economics 44(2),
pp. 293335.
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16
Protecting Insurance Portfolios

from Inflation
Ken Griffin and Edward Y. Yao

Conning Asset Management
The unprecedented steps taken by the Federal Reserve Bank of the

US towards monetary expansion since the financial crisis in 2008
have made the need to protect invested assets against inflation of
utmost importance. It is necessary to combine insurance company
modelling expertise with insurance asset management experience
to develop an investment solution that will help to protect the value
of a portfolio during periods of accelerating price inflation.
INFLATION HISTORY AND OUTLOOK
Inflation in the US has been stable and low since the 1990s. Since 1980,
the annual inflation rate, measured by the change of the Consumer
Price Index-All Urban Consumers (CPI-U) over a 12-month period,
has declined from above 10% to the 24% range (Figure 16.1). During
the Great Recession starting in 2008, it decreased well below 2% and
into negative territory. However, high inflation is more common if
we look at global inflation over a longer history. There were periods
of runaway inflation in the late 1970s and early 1980s in the US, but
it was still dwarfed by the inflation in some other countries. Brazil
was one notable example, with inflation north of 1,900% in 1989 and
2,400% in 1993. In most years from 1980 to 1994, the inflation rate in
Brazil was into three digits.
Since the 1980s, the Federal Reserve Bank in the US has changed
its monetary policy to stabilise inflation within a range (as central
banks of many other countries around the globe, including Brazil,
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Figure 16.1 US annual consumer price inflation
Inflation (%)
16
14
12
10
8
6
4
2
0
2
4
1950
1960
1970
1980
1990
2000
2010
Source: US Bureau of Labor Statistics; Conning Risk & Capital Management

Solutions Analytics.
Figure 16.2 Inflation expectations track past inflation average

6
5
Inflation (%)
Mean survey of
professional forecasters
5Y moving average
US CPI-U inflation
3
2
1
0
1
2
12M US CPI-U
inflation
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Source: US Bureau of Labor Statistics; US Federal Reserve Bank of Philadelphia;

Conning Risk & Capital Management Solutions analytics.
have done). However, it is not clear at the time of writing whether

central banks will be able to rein in inflation at the right time to the
right level.
In fact, inflation expectations from economists, consumers and
investors alike often reflect not much more than a moving average
of realised inflation rates, so it is doubtful whether they can really
be forward looking. In Figure 16.2, the mean forecast of long-term
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PROTECTING INSURANCE PORTFOLIOS FROM INFLATION
Figure 16.3 Cumulative inflation: (a) actual versus expected and (b) five
year cumulative difference between expected and actual inflation
(a)
800
700
Expected inflation
(cumulative since 1957)
600
Actual inflation
(cumulative since 1957)
500
% 400
300
200
100
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
(b)
35
30
25
20
15
% 10
5
0
5
10
15
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: US Bureau of Labor Statistics; Conning Risk & Capital Management

Solutions analytics.
inflation rate from the Survey of Professional Forecasters by the US

Federal Reserve Bank of Philadelphia follows closely the five-year
moving average inflation rate.
Furthermore, increases in inflation are very often underestimated.
Although the risk of unexpected inflation is pervasive, people do
not anticipate inflation until it has manifested itself for an extended
period of time, at which point it takes longer for monetary policy to
be adjusted to bring inflation down to the target level. In addition,
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2020
2010
2000
1990
1980
1970
1960
1950
1940
1930
1920
2,800
2,400
2,000
1,600
1,200
800
400
0
400
1910
US dollars (billions)
Figure 16.4 Increased monetary base in the US
Shaded areas indicate US recessions. Source: Federal Reserve Bank of St Louis.
inflation tends to be serially correlated, with high inflation typically

followed by high inflation, and therefore its devastating impact is
cumulative.
Figure 16.3(a) compares the cumulative actual inflation versus
expected inflation since the late 1950s. The five-year moving average
actual inflation rate is used as inflation expectation. Figure 16.3(b)
shows the cumulative difference between expected inflation and
actual inflation at the five year horizon from 1957 to 2010. The difference swings between 15% and 30%. The cumulated impact of
inflation can be over- or underestimated for an extended period of
time. Based on the data in Figure 16.3(b), clearly its impact has
more often been underestimated, even though the magnitude of
underestimation was smaller.
Since the 2008 financial crisis, in order to support economic
growth, central banks have generally kept interest rates low and
pumped liquidity into their economies. As of October 2011, the US
Federal Reserve has had two quantitative easing (QE) programmes,
whereby they purchased hundreds of billions of US dollars of securities from the capital markets in order to increase liquidity in
the financial system. Figure 16.4 shows how, as a result, monetary
supply skyrocketed in the US after 2009.1
In our opinion, the probability of high global inflation sometime
in the future has greatly increased. The first signs of such trend
are already showing up in emerging markets like China, prompting these countries to raise interest rates in an attempt to cool down
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their economies. The extended period of low inflation in the postVolcker era might be contributing to a false sense of security, while
increasing the likelihood of underestimating inflation in the future.
A reasonable level of inflation in line with expectations is generally not a big threat for businesses and consumers, as nominal
prices including output prices and wages should adjust accordingly.
However, the insidious risk is an unexpected change in the rate
of inflation, especially in the environment at the time of writing,
where there are reasons to believe traditional measures of inflation
expectations might be misleading. Therefore, inflation risk should
be carefully analysed, as it can negatively affect both consumers and
businesses. This issue is particularly acute for property and casualty
(P&C) insurers: a topic discussed in the next section.
INFLATION RISK FOR PROPERTY AND CASUALTY
COMPANIES
Property and casualty (P&C) insurers are exposed to a wide variety
of risks that must be managed within a companys risk tolerance.
For example, the risk of catastrophic weather events can be managed
through property location diversification or reinsurance, while other
risks are more difficult to protect against.
Among such challenging exposures is the risk of unexpected
(higher) inflation, which tends to be an insidious peril that grows
over time and affects all key financial metrics of an insurer. On the
liability side of the balance sheet, claim payments accelerate beyond
expected levels and additional reserves are required in anticipation
of higher claims, often leading to poor underwriting results as liabilities exceed incoming cashflow streams. Company expenses also
escalate beyond expectations.
The magnitude of the impact on a companys performance
depends on a host of factors. Obviously, first in line is the impact of
inflation on liability payments. But other issues are also important,
such as the ability to pass higher costs (due to higher inflation) to the
customers, the magnitude of the upside run in prices and how long
the inflationary period lasts. Finally, the adverse impact on reserve
adequacy is more manifest on liabilities further in the future, as inflation surprises have a longer time to cumulate, thus increasing cashflows payable. Clearly, it is not just liabilities that are exposed to an
inflation surprise, as higher interest rates will also affect negatively
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Figure 16.5 Dynamic financial analysis of the insurance enterprise

Evaluation of
economy and capital
markets
Underwriting
analysis
Asset analysis
Financial
statement
projections
Financial
analysis and
reports
Source: Conning Risk & Capital Management Solutions.
many assets on the opposite side of the balance sheet, including

bonds and equities, thus contributing to the underperformance.
A SIMULATION APPROACH
How significant is the risk of unexpected inflation to an insurance
company? We adopted a dynamic financial analysis (DFA) approach
(a stochastic simulation of the relevant cashflows), to answer this
question and more; although the topic concerns investment strategy, the importance of the DFA approach goes beyond the investment strategy itself. The framework that was applied in our analysis of inflation protective investment strategies can also be used to
improve other business decisions. In terms of risk management,
with this approach, the risks will not be managed in silos but in
an integrated system. Our analytical framework is illustrated in
Figure 16.5.
A DFA model includes an enterprise model, which simulates the
company at hand, and an economic scenario generator (ESG), which
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simulates the economic and capital market environment facing the

company. The output of an ESG is a set of simulated scenarios over
time (or paths) that portray future economic and capital market conditions in terms of macroeconomic indicators, such as inflation, GDP,
interest rates and returns of various asset classes, such as bonds and
equities. These scenarios are used as an input into the enterprise
model where the companys assets, liabilities and business operations are evaluated under each of these scenarios. Each evaluation
generates a set of multi-period financial measures reflecting different aspects of the companys financial performance in the future.
Pro forma financial statements are constructed across each economic
scenario and under various accounting bases. In this way, realistic distributions of various financial metrics develop in a consistent
manner.
For the purposes of this chapter, we model a hypothetical insurance company, with an assetliability profile similar to the average
US P&C company. Economic value is used to measure the value of
the insurance company and is defined as the market value of current plus future assets (ie, new business the company might develop)
minus the present value of liabilities and taxes. Economic value is
not observable,2 but it avoids the distortions of regulatory accounting regimes, since it marks all assets to market, accounts for the time
value of money and thus makes the values of different companies
easier to compare with each other. Clearly, there are a lot of assumptions that go into this calculation, particularly in projecting future
business and cashflows, and in the assumption of what the relevant
discounting curves ought to be.
Statistically speaking, economic value is a stochastic process. Its
volatility will be used in this chapter as a measure of economic risk,
in order to capture the possibility that the future economic value of
the insurance company might be different from ex ante expectations.
ECONOMIC VARIANCE DECOMPOSITION
There are four major risks borne by a P&C company: real underwriting risk, asset risk, liability discount rate risk and inflation risk (ie,
liability cashflow risk).
1. Real underwriting risk is the uncertainty of economic value
caused by unexpected changes in the loss ratio. For example,
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Table 16.1 Asset allocation details

Invested assets
Fixed income:
US Government
Municipals
Corporates
Mortgage-backed securities
Asset-backed securities
Collateralised mortgage obligations
Other
Common stock
Preferred stock
Other assets
Total lines
Allocation (%)
11.0
31.9
20.6
5.6
4.5
4.1
1.9
12.1
1.5
6.9
100.0
a sudden increase in claim frequency and/or severity due to

some natural catastrophe can lead to an unexpected increase
in the loss ratio and a decrease in underwriting profit.
2. Asset risk is the economic value uncertainty, which is due to
unexpected changes in the market value of assets. The average
US property and casualty industrys liabilities and investment
profile was used as input in the model (Tables 16.1 and 16.2).
Future business was projected based on our study and outlook
on the industry.
3. Liability discount rate risk arises from the uncertainty in the
rates (US zero-coupon yields in this analysis) used to calculate
the fair value of liabilities.
4. Inflation risk was defined earlier as the risk that (at constant loss ratio) insurance benefits, which are a determinant
of cashflows payable, increase due to an increase in inflation.
The decomposition of economic value risk over one-year and fiveyear time horizons is shown in Figure 16.6. A one-year horizon is
relatively short, but it is an interesting case, as it is the horizon often
used by regulators and rating agencies to evaluate economic capital.
The five-year horizon better captures the cumulative impact of economic events in the model. This longer time frame also corresponds
to the typical budgeting horizon of many insurance companies
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Table 16.2 Liability composition details

Allocation of loss
and reserves (%)
Lines of business
Private passenger auto: liability
Private passenger auto: physical damage
Homeowners
Commercial auto: liability
Commercial auto: physical damage
Workers comp.
Commercial multiple peril: liability
Commercial multiple peril: property
Other liability
Products liability
Medical malpractice
Fire
Allied lines
Inland marine
Reinsurance
All other lines
16.0
0.8
3.7
4.5
0.1
20.8
4.8
1.8
21.3
2.9
5.2
0.8
0.9
0.6
7.7
8.2
Total
100.0
Source: Conning Risk & Capital Management Solutions.
Proportion of economic risk (%)
Figure 16.6 Decomposition of variance of economic value

Real underwriting
Inflation
Discount rate
Assets
60
50
48
43
40
29
30
23
20
21
15 13
8
10
0
One-year horizon
Five-year horizon
Source: Conning Risk & Capital Management Solutions analytics.
(three-to-five years), and provides a reasonable base for investment

planning.
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Figure 16.7 Negative impact of higher inflation on insurers equity value

Baseline
Inflationary shock equity
3.5
700
3.0
2.5
650
2.0
600
1.5
550
1.0
500
450
Inflation shocks (%)
Equity value (US$ billions)
Inflation rate shock

750
0.5
2010
2011
2012
2013
2014
2015
Source: based on Connings insurance company simulation results.
As shown in Figure 16.6, inflation risk is not that significant (15%)

over the one-year period, but its importance increases over time and
can dominate over longer horizons. Indeed, over the five-year horizon, inflation risk is the largest contributor (48%) to overall economic
risk.
INFLATION IMPACT ON INSURERS EQUITY
In this section, we analyse the effect of an inflation shock on combined equity value of the insurance sector. As inflation increases,
the other variables (eg, discount rates) will also change, as the evolution of all these risk factors in the model is calibrated to historical
experience (where they are correlated). Liabilities will also typically
increase, leading to erosion in equity value. The inflation shock is two
standard deviations from a baseline of about 2% (at year 0 = 2010) to
5% (at year 2 = 2012), after which inflation starts to revert towards
its baseline (Figure 16.7 shows the first five years as per our horizon).
Changes to insurers equity value are primarily driven by net
income (which turns negative) and (unrealised) investment losses.
Figure 16.7 shows how damaging and long lasting an accelerating
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inflation rate can be to the insurance industry. By year 3 (2013), higher

inflation leads to a 20% loss in equity value, from the US$619 billion
baseline to about US$498 billion.
PROTECTING AGAINST INFLATION RISK
What makes an ideal investment strategy to protect an insurance
company from inflation risk? Insurance companies need investment income to supplement their underwriting income, in particular when markets are soft and price competition is fierce. Good
investment strategy helps insurance companies to grow their capital
without disproportionately increasing their risk exposure.
Because both assets and liabilities of insurance companies are sensitive to inflation, a protective investment strategy provides a way to
hedge inflation risk on both. Specifically, an ideal inflation-hedging
strategy for an insurance company should
1. be well diversified and relatively inexpensive to implement,
2. enhance the economic value of the company on a risk-adjusted
basis (in other words, improve the economic value efficient
frontier),
3. not subject the company to substantially higher capital charges
from the regulatory or rating agency perspective,
4. not substantially reduce investment income.
Using inflation-sensitive assets to protect against inflations harmful
effects offers the opportunity for higher investment returns without onerous capital demands and investment income reductions.
Through advanced modelling techniques, the optimal asset allocation can be customised in line with an insurers specific business,
tax position and risk and reward preferences.
DIFFERENT ASSETS IN INFLATIONARY PERIODS
The first step in the analysis is to investigate historical returns of
different asset classes, particularly during inflationary periods. We
collected data from different sources, including the US Consumer
Price Index (CPI-U) from the US Bureau of Labor Statistics for inflation, equity and commodity indexes from Bloomberg, fixed-income
indexes from Barclays Capital and a convertible bond index from
Merrill Lynch. In researching several decades of US inflation data,
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Figure 16.8 Twelve-month rolling annual US inflation (19482010)

0.15
Twelve-month inflation (%)
0.13
0.11
0.09
0.07
0.05
0.03
0.01
0.01
0.03
0.05
1950
M1
1960
M1
1970
M1
1980
M1
1990
M1
2000
M1
2010
M1
Sources: US Bureau of Labor Statistics; Conning Risk & Capital Management

Solutions analytics.
we found that periods of increasing inflation occurred frequently,

and some lasted for several years (Figure 16.8). We identified 10
inflationary periods (indicated by the grey areas in Figure 16.8)
by measuring inflation by its rolling 12-month average. As seen in
Figure 16.8, the US experienced an inflation environment for almost
half of the time between 1948 to 2010. The 12-month rolling inflation
rate during these periods was about 2.4%.
As the rate of inflation increases, the following years inflation
rate is likely to be higher as well, as consumers and businesses
begin to expect greater price changes due to positive serial correlation of inflation. Since unexpected inflation is more damaging to
insurers than high but stable inflation, we focused particularly on
increasing inflationary episodes that act as a proxy for unexpected
inflation increases. During these periods, we found that most asset
classes, particularly fixed-income investments, performed poorly.
For instance, from 1948 to 2010, the annual total return of the S&P 500
index has a negative (15.6%) correlation with inflation; similarly,
from 1976 to 2010 (the difference in dates depends on the availability of index data), the annual total return of the Barclays US Aggregate Bond Index has a negative (24.6%) correlation with inflation
(calculated on a calendar year basis).
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There were, however, certain asset classes that generated superior performance relative to the overall market. Hard assets sectors with exposure to commodities used in industrial production,
as well as precious metals, generally outperformed during inflationary periods. Energy sectors and energy commodities such as
petroleum-based products were also strongly positively correlated
with inflation, and were often previously the underlying cause of
higher inflation. Exposure to these hard asset sectors and commodities can be gained through the futures market, financial vehicles
such as exchange-traded funds (ETFs) or direct equity investments
in companies that benefit from commodity price increases. Other
select sectors, such as real estate, retailing, materials and technology
also provided solid returns. Convertible bonds in inflation-sensitive
sectors are a capital-efficient way for insurers to gain equity-like
exposure while still maintaining a relatively high level of investment
income.
Other financial vehicles are directly linked to the inflation rate
itself. Treasury Inflation Protected Securities (TIPS), are indexed to
the US CPI and accrue additional principal at the rate of inflation,
although, in a low inflation environment, TIPS will produce lower
investment income than most other fixed-income investments. Inflation swaps also can provide inflation protection, as a fixed rate of
interest is paid in return for the rate of inflation realised over the
period of the swap. No cash outlay is required, but insurers will need
to meet certain regulatory standards (such as filing a Derivative Use
Plan, which is a legal requirement in many US states) before executing an agreement, and would be subject to the swap mark-to-market
volatility.
Floating-rate notes can also provide inflation protection, as the
underlying rate should adjust to a higher level along with inflation.
When additional credit or liquidity spreads are present, these might
also provide yield enhancement and extra income.
INFLATION-HEDGING ASSETS AND EFFICIENT FRONTIER
Based on the historical analysis of long-term dynamics of inflation,
economic growth, interest rates and returns of different asset classes,
we calibrated the economic and capital market simulation model to
provide realistic scenarios for economic indexes and asset returns.
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Figure 16.9 Risk and return of various asset classes

12
Private equity
11
Average total return (%)
10
US equities
Convertibles
Infl.
equities
High yield
Commodities
MBS
6
5
EAFE
FRN
Hedge funds
4
3
Cash
2
1
Gov.
Corp.
Muni.
TIPS
20
25
30
35
0
0
10
15
40
Standard deviation (%)

Figure 16.9 displays the average and standard deviation of our

modelled asset class returns (the multiple points for government,
corporate and municipal bonds along with TIPS represent multiple
maturities).
We selected five inflation-hedging assets, which are US TIPS, inflation protective equities, commodities, floating rate notes and convertibles. Inflation protective equities include the energy, retailing,
materials, technology, hardware & equipment and the real estate
sectors. Commodities include the crude oil, industrial metals and
precious metals sectors.
Certain asset classes such as TIPS and floating-rate notes had
a low-risk, low-return profile, while others, such as commodities,
inflation-sensitive equities and convertible bonds, had higher risk
and return expectations. By running our industry model through
real-world economic scenarios, we tested the value of adding various allocations of our five inflation-sensitive assets to the insurance industrys investment portfolio. We then solved for the optimal
asset allocations that maximise the economic value of the industry
while minimising the economic risk, thus identifying the efficient
frontier.
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Average economic value
Figure 16.10 The efficient investment frontier(s) for economic value

(five-year horizon)
960
940
920
900
880
860
840
820
800
F
Add inflation swap
Add other inflation assets
Add TIPS
Baseline
PC industry
B
A
55 65 75 85 95 105 115 125 135 145 155 165 175 185

Standard deviation of economic value
AJ denote different efficient portfolios.Source: Conning Risk & Capital Management Solutions analytics.
Shareholder's equity
(US$ billions)
Figure 16.11 Insurers equity value

750
700
650
600
550
500
450
Baseline
Inflationary shock
Shock with inflation assets
2010
2011
2012
2013
2014
2015
Figure 16.10 shows several efficient frontiers for our hypothetical company, using the asset and liabilities profile of the average US P&C insurer. Each of the four lines in the chart is a plot
of the average and standard deviation of economic value of the
company at the five-year time horizon for a given set of instruments (weights varying depending on the riskreturn preferences)
allowed in the investment portfolio. The baseline is the efficient
frontier using the set of assets in Table 16.1. Note that the average weights in Table 16.1 do not correspond to an efficient portfolio (PC industry point in Figure 16.10). To this set (Table 16.1) of
investable assets, we add first US TIPS, then floating-rate notes,
commodities, inflation-hedging equities and convertibles; finally,
an inflation swap overlay is included. The isolated point in Figure 16.10 represents the average economic value of the insurer before
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the inclusion of inflation-hedging instruments in its investment

portfolio.
Several interesting insights can be gleaned from this type of analysis. First, including inflation protection in the industrys portfolio can
greatly reduce the overall risk and improve its future combined economic value. Asset portfolio returns are improved during inflationary periods, which help to offset the inflation risk held in the insurers
liabilities. During inflationary periods, when other traditional assets
such as bonds and equities are performing poorly, inflation-hedging
assets stabilise and protect economic value.
Second, while we see that TIPS provide risk reduction, the benefits
are typically seen at the lower end of the riskreturn spectrum, where
the addition provides a material shift of the efficient frontier up and
to the left (see the lower left corner in Figure 16.10). Instead, the
addition of commodities, inflation-sensitive equities and convertible
bonds to the investable set causes a material shift of the efficient
frontier at higher riskreturn levels (see the upper right corner in
Figure 16.10).
Third, when we include inflation protection, we can modestly
extend the duration of the current bond portfolio, which improves
portfolio yields and investment income. By protecting against inflation shocks with assets that have historically appreciated in value
in such episodes, we can afford this extension and the incremental
interest rate risk.
Finally, overlaying the portfolio with an inflation swap increases
average economic value or reduces economic risk across the board.
As a direct hedge against inflation with no cash outlay, an inflation swap provides an inflation hedge without having to reallocate
capital from other investment assets.
Figure 16.11 shows the evolution of the average insurers equity
value over time (baseline) and the effect of an inflationary shock. If
inflation-sensitive assets are included in the portfolio, the impact
on economic value from the same inflationary shock is greatly
mitigated.
TAILORING INFLATION-HEDGING STRATEGIES
Although we analysed optimal inflation-hedging investment strategies for our virtual P&C company with an average assetliability
profile, further analysis is needed to customise the strategy to
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any specific insurance company. The following are some important

considerations.
Long-tail liabilities versus short-tail liabilities
Payments for long-tail P&C liabilities are so called because they are
disbursed further into the future. This might be due to delays in
claim reporting, adjusting or settlement or the involvement of litigation, and often results in higher claim severity. These liabilities
usually include claims made under such coverage as workers compensation, medical malpractice, professional liability and general
casualty. Long-tail liabilities are more susceptible to inflation risk.
The insurance companies that underwrite long-tail insurance thus
have more need for inflation protection, and their investment strategy should be more heavily weighted towards inflation-hedging
assets.
In our analysis, we are able to vary the liability profile and
derive the optimal asset allocations for short- and long-tail lines
of business. As intuition suggests, the results show that the optimal investment strategy to protect long-tail liabilities from inflation
requires a greater allocation to long-maturity TIPS. Furthermore,
long-tail liabilities tilt the optimal portfolio towards more volatile,
higher-yielding assets, such as commodities and inflation-sensitive
equities, relative to short-tail liabilities, which tend to tilt the optimal investment strategy towards floating-rate notes and convertible
bonds.
Capital adequacy/credit rating
Insurance companies operate under many constraints and are heavily regulated. The regulators intent is to prevent the insurance companies from taking too much risk, and to protect policyholders. First,
regulators require the insurer to maintain a specific level of capital,
which will be a function of the type of asset in its portfolio, and
often their credit rating. Rating agencies also look at capital to determine the credit rating of the company, which is obviously a crucial
metric in the insurance business. Therefore, an insurers (inflation)
investment strategy needs to take into consideration both the riskbased capital requirements and the impact they might have on the
companys rating.
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Investment income
Some inflation-sensitive investments, such as commodities and
equities, do not pay coupons, or their dividend income is uncertain. Others, such as TIPS, have a lower fixed coupon yield than
most other fixed-income securities (although inflation might offset this). Therefore, the inflation investment hedging strategy might
decrease book yield in nominal terms, although it should result in
lower volatility from a balance sheet perspective, ie, when liabilities
are taken into account.
Risk tolerance
Different companies have different risk tolerances and may not use
the same risk measurement metrics. Different measurements and
risk tolerances will lead to different optimal strategies. For example,
a company with a higher risk tolerance is likely to have a larger
allocation to commodities and inflation-sensitive equities, while a
company with a lower risk tolerance will gravitate towards TIPS
and floaters.
INFLATION RISK FOR LIFE INSURANCE COMPANIES
While most of the impact of inflation on P&C insurers profitability is tied to the adverse growth in claim payments, life insurance
companies are exposed in a different manner.
In fact, investment portfolios of life insurance companies are heavily weighted towards fixed-income investments such as government
and corporate bonds, and residential and commercial mortgages.
These investments typically pay fixed rates of interest and have
maturities much longer than those typically held by P&C companies.
As capital markets react to an inflation surprise, interest rates will
rise, decreasing the market value of these long-term fixed-income
investments. Depending on the timing of the investment purchases,
the unrealised loss position of the life insurers portfolio will grow,
leading ultimately to realised losses if and when the company needs
to sell assets.3
On a statutory accounting basis, realised losses are absorbed first
by the interest maintenance reserve (IMR) and then, once IMR is
depleted, by the companys capital, which will impair the insurers
ability to underwrite new business. On a Generally Accepted
Accounting Standards (GAAP) basis, losses will flow through to
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the company income statement, and both income and capital will
suffer.4 On an economic basis, the economic value of the company
will depend on the duration management of both sides of the balance sheet. If the duration of the assets is shorter than the duration
of the liabilities, the market value of the assets will fall less than the
market value of the liabilities such that the net surplus (assets minus
liabilities) position may actually benefit. However, if the reverse is
true and the asset duration is longer than the liabilities, the economic
value of the company may fall. Prudent assetliability management
is crucial in measuring and understanding this dynamic.
Beyond duration risk, negative convexity may also negatively
affect a life companys surplus position. Life companies typically
sell options on both sides of the balance sheet. For instance, on the
liability side, they give policyholders the right to lapse their policies
when interest rates rise and receive their policy cash values, which
may cause the company to sell assets just when market values have
been impaired. On the investment side, life companies often make
investments, such as mortgage-backed securities, that allow for the
return of funds to the company when interest rates fall, requiring
reinvestment in a lower yielding environment. The net effect is that
life companies typically suffer when there are large swings in interest
rates, regardless of the direction of the rate changes. Rapidly rising
interest rates in an increasing inflation environment are no exception.
Like P&C companies, life companies are exposed to higher
expenses during inflationary periods. Unlike P&C companies, which
may have some ability to re-price renewable policies during times of
increased inflationary pressure, life policies often require long-term
fixed contracts, which are priced using ex ante long-term inflation
projections. When actual inflation turns out to be higher than these
initial assumptions, life companies have a limited ability to recoup
the higher costs that result.
While inflation risk for life insurers can be significant, a mitigating
factor is that most life insurance benefits are not directly indexed to
inflation, to the contrary of what happens for P&C companies, who
must typically pay the full replacement cost of the insured item.
CONCLUSIONS
Given the monetary and economic environment at the time of writing, inflation risk is more relevant than ever. Simulation results
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clearly show that the latter can indeed be the greatest financial risk
faced by P&C insurers, at least at long horizons (five years or more).
Asset classes that perform well during periods of higher inflation
are few, and those that exist have different characteristics and qualities. To lead to optimal enterprise performance, a successful strategy
must combine the knowledge required to invest in inflation-sensitive
assets, with the management experience and understanding of the
insurance business, and the needs of the specific client at hand.
All rights reserved. Protecting Insurance Portfolios from Inflation is licensed to Incisive Financial Publishing Ltd by Conning
Asset Management (Conning) and may not be reproduced or
disseminated in any form without the express permission of Conning. This publication is intended only to inform readers about
general developments of interest and does not constitute investment advice. While every effort has been made to ensure the accuracy of the information contained herein, Conning does not guarantee such accuracy and cannot be held liable for any errors in or
any reliance upon this information.
Conning does not guarantee that this publication is complete.
Opinions expressed herein are subject to change without notice.
Past performance is no indication of future results. Conning is
a portfolio company of the funds managed by Aquiline Capital
Partners LLC (Aquiline), a New York-based private equity firm.
1
However, as a counterargument, it is clear from Figure 16.4 that money velocity plummeted
during the same period.
For listed companies, stock price is a measure of economic value, although technical effects
can at times be important.
Clearly, what matters at the end is the duration difference between assets and liabilities.
Statutory accounting rules apply specifically to insurance companies. GAAP accounting

covers a wider range of public and private companies.
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17
Inflation, Pensions and

Liability-Driven Investment Solutions
Markus Aakko
PIMCO
Pension plans play a significant role in most developed market

societies. As investments, they provide capital to the economy; as
funded pools of savings, they provide security to millions of retirees.
Changing demographics have put the solvency of several pension
schemes to the test, as ageing societies mean more retirees and fewer
participants contributing to the savings pool.
In developed markets, most of these pensions are stated in nominal terms, but some are tied to price indexes. If inflation were to
rise substantially, more pension funds may choose to provide some
indexation. Consequently, finding ways of mitigating inflation has
become important for most pension managers, as inflation is one of
the potential risks associated with the solvency of their schemes.
In this chapter, we focus on how inflation can potentially influence
the solvency of pension funds; we review how private pension plans
in selected countries differ in their pension commitments, and methods of assessing the required contributions to the plan. We find that,
while many countries have private pension systems with exposure
to inflation, the discount curves used for valuation are almost always
based on nominal rates: in other words, inflation is usually implicitly
included as a forward-looking expectation in liability estimates.
Using the example of a US pension fund, we review the types of
analytical tools that can be used to measure the inflation sensitivity
of a pension plan, and also how traditional risk budgeting processes
and risk decomposition techniques can be expanded, using a factor
model that uses unanticipated inflation as one of the factors.
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We conclude by reviewing some of the instruments and strategies

that can be used to mitigate inflation risk, and discuss their efficacy
as inflation hedges and the degree to which they are employed in
practice by pension plans in selected countries.
INFLATION INDEXATION OF PENSION BENEFITS AROUND
THE WORLD
The typical model of pension financing revolves around pre-funded liabilities, ie, an arrangement where funds (from the pension
sponsor1 and/or plan participants) are set aside and invested in
order to meet future liabilities (pension benefits). In the past, pay-asyou-go models, where current workers contributions and/or taxes
pay benefits payments to current retirees, dominated most countries,
as corporations and governments abilities to meet their obligations
were viewed as infinite, in the light of continuing population and
productivity growth. The rebalancing of economic power between
developed and emerging economies, and the demographic trends
underlying that rebalancing, are calling into question the creditworthiness of those future promises. Hence, most countries have
moved towards requiring substantial down payments for future
cashflows in the form of pre-funded pension plans.
A primary objective of most pension sponsors and any contributing participant is to minimise required contributions to the pension
fund over the life of the scheme. Contributions at any given point
in time are driven by a combination of asset returns, liability discount rate assumptions, actuarial projections and, often, the local
regulatory framework.
The pre-funding of these liabilities has, in turn, created the necessity of being able to value the future liabilities accurately. Given that
cashflows associated with future liabilities can be estimated with a
reasonable degree of accuracy, traditional discounting models can
be used to estimate the present value required to fund the future
commitments. Actuarial projections usually include an assumption
for inflation, since many schemes are based on average or final pay
formulas, or include an explicit tie to inflation through cost-of-living
adjustments (COLAs). Required contributions may rise, therefore, if
inflation exceeds the assumed rate.
There is a distinct difference between open plans, with new participants earning future benefits, and closed or frozen plans, where
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INFLATION, PENSIONS AND LIABILITY-DRIVEN INVESTMENT SOLUTIONS
Table 17.1 Private pension plans indexation policy

Country
Indexation policy
US
Only a small percentage (3%) provide

automatic adjustments
UK
Netherlands
Mandatory up to 5% per year

Most plans have conditional indexation
based on funds solvency
Not mandatory
Canada
benefit payments are largely predetermined. For closed and frozen

plans, the expected shape of the liability is substantially more predictable and the plans sensitivity to inflation is also more stable as
there are no further benefit accruals.
In the US, most private pension promises do not carry a COLA,
and because of this they are nominal obligations that tend to decrease
in real terms during inflationary periods. In 1995, only 7% of private
plans had a provision for inflation indexation, and only in 3% of the
cases the plan had an automatic escalator (Mitchell 2000, p. 13).
While inflation may not be fully included in the benefit formulas,
in cases where pension benefits are calculated as a result of final or
average wage, inflationary periods in excess of actuarial expectations may also alter the liability in relation to the supporting asset
pool. This is the most common way in which US private pension
funds end up having sensitivity to inflation. The link is, however,
weaker than an explicit COLA.
Comparatively, in Europe, practices vary by country. The UK has
an explicit link between pension promises and inflation, even for
privately organised schemes (Davis 2000), and the Netherlands (the
second largest private market in Europe) typically has indexation
built into the benefit formulas, although the latter are often conditional to the fund being in sufficient health to support such increases.
In many, if not most, countries the public part of the pension system
(eg, Social Security in the US) is fully indexed to inflation (Piggott
and Sane 2009, pp. 89).
The inflation sensitivity of pension plans varies by country, by
industry, by sponsor and by plan. In some cases, benefit payments
linked to inflation may be provided to one class of participants and
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not others; this may happen, for example, as a result of corporate

mergers.
The assumption that nominal pension benefits have no inflation
sensitivity is most likely wishful thinking. Pensioners may be able
to tolerate small amounts of inflation (12%), but are unlikely to be
able to adjust to sudden and prolonged bouts of much higher, say
10%, inflation, simply because the fall in purchasing power under
such a scenario becomes disruptive. As an extreme example, German
hyperinflation in 1923 was particularly hard for those with savings
or living on fixed income, eg, pensioners.
In the US, it has been observed that pension plans have resorted
to voluntary increases in benefits during periods of inflation. Nonformulaic one-time increases in private-sector pension plans were
prevalent in the inflationary period of 197881, when about 40% of
retired pension plan participants received increases (Schmitt 1984),
and less so during the subsequent disinflationary period, when only
6% did (Weinstein 1997). Presumably, no pension plan can provide
such benefits merely out of kindness: these are ultimately arrangements where the sponsor must step up to the plate in order to
make good on the pension promises, which ultimately are viewed
by participants as a form of deferred compensation.
A BRIEF HISTORY OF INFLATIONARY PERIODS
While the spikes in inflation throughout the 1970s had perplexed
investors and economists alike, the issue suddenly became an
anachronism over the last two decades of the 20th century, when
inflation and volatility were both on a sustained downtrend. In the
early 2000s, however, lack of fiscal discipline in the developed world
economies, consumption growth in emerging markets and overall
demographic headwinds raised concerns about what may lie ahead.
During inflationary periods, all monetary obligations, including
wages and pension benefits, are affected by rising price levels. Historical experience (from developed markets in the 1970s, and many
Latin American markets in the 1980s) shows that, once sufficiently
high price-change thresholds have been reached, most economic
agents become concerned about inflation. Nazmi (1996, pp. 1314)
identifies indexation as typical of economies with chronically high
inflation, which he defines as persistent double-digit inflation not
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Figure 17.1 Annual inflation rate in the US

25
20
15
10
%5
0
5
10
15
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Source: US Bureau of Labor Statistics.
exceeding 50%. Inflation can also feed further inflation, as indexation removes the ability of a reduction in real cost of production, postpones the necessary adjustments and makes the economy
susceptible to exogenous shocks (Durevall 1998).
Humankind has known inflation at least since records of prices
began. Often driven by local weather, prices of grain would fluctuate,
driving the cost of living up and down, as costs associated with
transportation did not allow for substantial trade between areas with
food surpluses and deficits (see, for example, Fischer 1996, pp. 923).
Another strong influence on price levels came from new discoveries
of precious metals, used as money through the expansion of money
supply (Pettee 1936).
The modern period2 saw the establishment of central banks
and monetary policy, and a shift in inflationary tendencies: weather
plays a diminished role due to robust logistical networks around the
globe, and the main drivers of inflation are now supply and demand
of key commodities, labour costs and the activities of central banks.
During the 20th century, the key events that shaped public consciousness of inflation were the hyperinflationary period in Germany (1923), which gave the German Central Bank (the Bundesbank,
established in 1957) and its effective successor, the European Central
Bank (ECB), a permanently hawkish tone, the deflationary period
during the Great Depression in the US (1930s) and the inflationary
decade of the 1970s in most Western countries.
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In each period, further damage came from misunderstanding

the root causes of inflation, and the flawed policy and monetary
medicines that were administered. Price controls existed in both
deflationary (Shlaes 2007, p. 225) and inflationary (Rockoff 1984,
pp. 92, 203) periods. In both cases, the result was an imbalance in
supply and demand: unemployment in the 1930s and fuel shortages
in the 1970s.
Forecasting inflation also has a chequered history: many investors
expected the return of deflation after World War II and, against many
professional financial projections (Scitovsky 1979), inflation was subdued after the 1970s, with the expectation of price stability pervading the following decades, and only modest inflation since. Looking
forward, most investors would agree that it is unlikely for inflation
to be negative over sustained periods of time. While, theoretically,
inflation and deflation may both occur, central banks generally have
a bias, if not an explicit target, towards a stable, low rate of positive inflation. With explicit inflation targeting common in developed countries, it is less likely that inflation will be allowed to grow
unchecked; most central banks have a specific mandate to maintain
price stability, and the effective tools to tackle inflation when needed.
HOW CHANGES IN LIABILITY AFFECT CONTRIBUTIONS
Fluctuations in the market value of assets and liabilities change the
surplus of pension funds.3 For example, based on the way pension
liabilities are discounted, a fully funded plan invested mainly in cash
might become underfunded if interest rates were to fall. But rates
could rise again in the future, reversing the underfunding. In other
words, provided that these fluctuations are mean reverting, surplus
volatility should not particularly matter in the long run. The drivers
of surplus volatility are
returns on asset pool,
changes in liability discount rates,
changes in liability cashflows, through COLAs and/or actuar-
ial assumptions.
As mentioned earlier, pre-funding liabilities mitigates the risk of
whether of not the company will actually meet its pension obligations in the future (in other words, the counterparty risk of
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the company). Furthermore, national legislation typically defines

the requirements for pre-funding, and accounting practices4 have
evolved to recognise unfunded parts of the pension fund on corporate balance sheets, as a form of implicit debt (Yermo 2007).
In essence, these provisions take the pension funds close to full
mark-to-market accounting.
Liability-driven investing, which has gained traction in the US, the
UK and many countries in continental Europe, is most commonly
defined as the practice of adjusting the investment policy of the asset
pool to match the reference rates used to discount liabilities. The liability discount rate has a sizeable impact on most plans surpluses,
and therefore significantly affects the variance of future contributions. Consequently, when the returns of the asset pool and changes
in liability value are strongly correlated, the expected variance of
future contributions is reduced.
As illustrated by Table 17.2, the impact on actual contributions is
a function of country and other considerations. While most countries do not require immediate contributions when plans fall into
deficit, many sponsors may be sensitive to the impact on their balance sheet through applicable accounting rules. This results in a
greater focus on short-term movements in the surplus. Therefore,
focusing on surplus volatility is the most efficient way of managing
the assetliability mismatch of pension funds.
There has been a global debate about whether the discounting of
future cashflows should be done using a government curve, a swap
curve or a corporate bond curve. When liabilities are expressed not
in nominal but in real terms (in other words, when they are indexed
to inflation) the framework for determining fair value becomes even
more complicated. The appropriate discount rate for credit-risk-free
inflation-adjusted liabilities is the government real rate curve, ie,
the curve derived from inflation-indexed government securities.5
Of course, this is satisfactory only if the pension liabilities and the
government inflation-linked bonds are tied to the same index (for
example, the consumer price index (CPI) for US inflation). On this
point, however, note that pension benefits are often closely related
to wage growth.6
Because of the implementation of this mark-to-market framework, the major contributors to most plans surplus volatility are
the returns on the asset pool and changes in the liability discount
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USA
2,121
Corporate AA
Corporate AAAA
bonds
Usually 7 yr
UK
1,485
Corporate AA
Trustees select
discount rate basis
Usually up to 10 yr
PPF
Euro-swap curve
Usually up to 15 yr
None
Commuted value
assumptions,
depending on
liabilities
5 yr; in some cases

up to 15 yr
None
Netherlands
Canada
Ontario
Discount
curve
(accounting)
1,079 High-quality
corporate bond rate
(IAS 19)
845
Yield on high-quality
fixed income
Discount
curve
(funding)
Deficit
amortisation
National
insurance
PBGC
has one for the Province. PBGC, Pension Benefit Guarantee Corporation. PPF, Pension Protection Fund. Accounting curve: the discount
rate used to determine the present value of liabilities in the financial statements of the sponsor. Funding curve: the discount rate used to determine
the present value of liabilities for assessing the required annual contribution under local pension regulation. Deficit amortisation: the period defined
by local pension regulation as the maximum allowed for calculating the required annual contribution. For example, a seven-year amortisation means
that any deficit must be funded in installments over seven years or less. National insurance: collective, typically government-sponsored, funds that
act as insurance for participants against insolvency of pension plans.
Sources: Halonen (2011), data as of December 31, 2010; Pensions Protection Fund (2010); OECD (2007).
perrucci 2012/7/11 17:12 page 396 #418
Country
Private
pension
assets
(US$ bn)
396
Table 17.2 Private pension plans discount curve and other characteristics
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Table 17.3 Example: US private pension plan

Assets
(US$ million)
Liabilities
(US$ million)
Equities
Fixed income
216
540
Present value
of liabilities
1,000
Alternatives
144
Total assets
900
Total liabilities
1,000
rate. These are also the most easily observable changes in real time,
as actuarial calculations are usually done infrequently,7 and inflation
indexes are typically released with a lag of several weeks or months.
MEASURING THE INTEREST RATE SENSITIVITY OF
LIABILITIES
Most plans measure their sensitivity to changes in discount rates
using interest rate duration. By calculating duration on both assets
and liabilities, we can use the difference (the duration gap) to estimate changes in the surplus based on various market scenarios. Most
plans are underweight in duration, which is to say that their liabilities have a substantially higher sensitivity to changes in interest rates
than their assets do.
As an illustration, consider the example of a hypothetical US pension plan that is 90% funded ($900/$1,000), and has 60% of liabilities
whose cashflows are linked to CPI.8 The plan has also taken significant steps towards reduction of surplus volatility through duration
overlay strategies. The characteristics of this pension plan are shown
in Table 17.3. The plan employs an interest rate swap overlay for a
notional amount of US$540 million (60% of assets) with duration of
8.7 years. Due to a recent merger of two corporate plans (one with full
indexation and one entirely nominal), 60% of pension liabilities are
indexed to inflation through a COLA. The overall liability duration
is 12.7 years. The resulting balance sheet is shown in Table 17.4.
The duration of assets is the sum of the weighted duration of equities and fixed income securities, that is 8.2 years, while liabilities have
a weighted duration of 14.1 years, leaving a negative duration gap
of 5.9 years. In other words, a rise in interest rates is beneficial, as
it decreases the amount by which the pension fund is underfunded.
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Table 17.4 Duration contributions
Weight
(% of assets)
Equities
Fixed income
Overlay
Alternatives
Liabilities
Duration
(years)
24
60
60
16
111
N/A
5
8.7
N/A
12.7
Weighted
duration
(years)
3.0
5.2
14.1
5.9
Total
Plan is 90% funded, and thus the liability expressed as a percentage of

assets is 1/0.90 = 111%.
MEASURING THE INFLATION SENSITIVITY OF LIABILITIES

Siegel and Waring (2004) suggested the use of dual duration to
measure the sensitivity of a pension plans surplus to changes in
both interest rates and inflation. Their premise is that changes in
nominal interest rates are driven by changes in real rates or inflation expectations, or both. Depending on the nature of liabilities, the
duration of each of these components may differ. Siegel and Waring
use the decomposition proposed by Fisher (1930, p. 39), where the
nominal interest rate n can be expressed as the sum of the real rate
r and expected inflation iEXP for the period
n = r + iEXP
(17.1)
Using this framework, we can distinguish between the sensitivity

to changes in real rates r, and sensitivity to changes in expected
inflation iEXP .9 Using the pension plan in the previous section, the
sensitivities of the assets, liabilities and the surplus are shown in
Table 17.5.
This example highlights the difference in changes in the surplus,
depending on whether the change is in the real curve or the inflation
expectations. Specifically, in this example, rising real rates (eg, higher
discount rates at constant cashflows) are beneficial to the plan, as
they increase the surplus; conversely, a rise in inflation expectations
embedded in actuarial projections (at constant real rates) has the
opposite effect, as part of the liabilitys cashflows are indexed to
inflation.
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Table 17.5 Real rate duration and inflation duration
Weight (%)
Real rate duration (years)
Inflation duration (years)
Assets
Liabilities
100
8.2
8.2
111
12.7
5.1
Surplus
5.9
2.6
That is 40% 12.7 = 5.1 years, reflecting the liabilities not linked to
inflation. We assume that there are no inflation-linked instruments among
the assets.
The implications of contribution requirements for the plan are further complicated, as liabilities are marked-to-market using nominal
discount rates, typically on a monthly basis, while a rise in inflation
expectations would be reflected through actuarial cash projections
on a less frequent basis (typically a few times per year). In addition
to delays, actuarial assumptions often include further lags due to
smoothing assumptions.
Using cashflow (inflation) duration also assumes that there is the
same change in inflation expectations for all terms across the yield
curve (this parallel shift assumption is common to all duration
measures). Finally, meaningful changes in inflation and interest rates
will typically not happen without some attendant changes in the valuation of other asset classes. As a result of the complex interrelation
of equity returns, spreads, interest rates and inflation, the duration
measure is a useful, but by no means comprehensive, measure of
risk.
RISK BUDGETING
Sensitivity measures such as duration are useful in evaluating
expected changes in surplus given changes in a single market variable. An alternative, and more comprehensive, measure is volatility or, in the case of pension funds, volatility of the pension surplus. To estimate surplus volatility, most plans use a covariance
matrix, derived from historical data, forward-looking views or some
combination of the two.
By obtaining an estimate for both surplus volatility and required
return on surplus, we can set up an optimisation problem. Specifically, using modern portfolio theory, it is possible to seek optimal
allocations of assets in order to minimise surplus volatility, under
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Table 17.6 Modelling assets and liabilities with proxy index
Asset class
Equity
Fixed income
Alternatives
Liabilities
Overlay
Wt
(%)
Vol.
(%)
S&P 500
24
BarCap US Aggregate
60
DJ/CSFB Hedge Funds Index
16
BarCap US Long Corporate A and higher 111
BarCap 10-year Swap Bellwether
60
16
4
8
9
8
Proxy index
the constraint of achieving the return required for the plan. The
resulting optimal allocation strategy is usually called a risk budget. As inferred by the name, a risk budget is meant to help pension
plan managers allocate a scarce resource, surplus risk, across various investments. A typical way of analysing the risk budget is risk
decomposition, which is the process of estimating the contribution
to surplus variance arising from each investment. If denotes the
row vector of weights for each asset in the portfolio, and denotes
the covariance matrix, we can calculate the overall variance of the
surplus (Litterman et al 2003) as
2 = T
(the superscript T indicates transposition). We can then decompose the overall variance into each individual assets contributions.
Letting i denote the ith row in the covariance matrix and 2 denote
the portfolio variance, the percentage contribution to the overall
variance for asset i is
i i
T
2
(17.2)
Risk budgeting can be expanded to include liabilities, in which

case the total volatility estimated through the covariance matrix
represents surplus volatility.
As a numerical example, we consider the pension plan of the previous sections, and use proxy index benchmarks for both assets and
liabilities, as detailed in Table 17.6. Our interest rate assumptions are
as follows.
(i) The pension plans liabilities are represented by the Barclays
Capital US Long Corporate A and higher, with a nominal
duration of 12.7 years (as before).
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Table 17.7 Correlation matrix

Equity
Fixed income
Alternatives
Liabilities
0.1
1.0
0.2
0.9
0.9
0.6
0.2
1.0
0.2
0.0
0.2
0.9
0.2
1.0
0.7
1.0
0.1
0.6
0.2
0.1
Overlay
0.1
0.9
0.0
0.7
1.0
Table 17.8 Surplus variance decomposition
Weight (%)
Equities
Fixed income
Overlay
Alternatives
Liabilities
Variance
decomposition (%)
24
60
60
16
111
25
11
13
4
95
Total
100
Table 17.9 Variance decomposition
Return-seeking
assets
Variance
contribution
(%)
Liabilities
and hedges
Equities
Alternatives
25
4
Liabilities
Fixed income
Overlay
Total
29
Total
Variance
contribution
(%)
95
11
13
71
Given that the liability proxy consists of corporate bonds, positive correlation between equities and corporate bonds reduces the contribution
to risk attributable to equities. If a Treasury index had been used to proxy
liabilities, equities and alternatives would have contributed a further 48%
to total surplus variance.
(ii) The fixed income assets are invested in the Barclays Capital
US Aggregate Index, which has a duration of five years.10
(iii) The interest rate overlay can be modelled using the Barclays
Capital 10-year Swap Bellwether Index.
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By using the appropriate covariance matrix (Table 17.7), we can calculate the total surplus volatility, expressed as a percentage of assets
or in US dollar terms. For our example, we obtain an overall volatility
= 6%, or about US$54 million (the assets value is US$900 million).
The next step is to decompose the overall portfolio variance into
its individual contributions, based on Equation 17.2 (Table 17.8). As
it is clear from this risk decomposition, the largest influence on the
total surplus variance comes from the liabilities (Table 17.9). Negative contributions to risk, from the fixed income sector (11%) and
the interest rate overlay (13%), are a result of their being hedging
assets, or, in other words, assets highly correlated with the liabilities,
thus reducing overall volatility.
It is useful to consider each asset and investment as either a returnseeking asset or a liability-hedging asset. Return-seeking assets
(equities and alternatives in our example), which typically do not
hedge liabilities, provide an opportunity for additional returns in
exchange for higher risk. Conversely, liability-hedging assets (fixed
income and the interest rate overlay in our example) reduce surplus
volatility, but their expected return might be less attractive compared
with the liability discount rate.
With this type of analysis, risk managers can refine their allocation process, reduce unwanted risks and optimally allocate their
risk budget and capital to asset classes, in line with the goals of the
pension fund. For underfunded plans, this may mean increasing
allocation to return-seeking assets, at the expense of hedging assets,
thus increasing the overall surplus volatility. For fully funded plans,
especially the ones that are closed to new entrants, the plans objectives may be best served by closely matching assets and liabilities,
and by minimising surplus volatility.
FROM ASSET-CLASS MODELS TO FACTOR MODELS
Each of the asset classes considered in the risk budgeting analysis
above is sensitive to several risk factors, including interest rates,
inflation and equity. Some sectors embody one risk factor in particular (eg, US Treasuries have interest rate and inflation risk; common
shares mainly have equity risk), while others present a more complex combination of sensitivities (eg, convertible bonds are sensitive to interest rates, inflation, volatility, equity prices and corporate
spreads).
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Traditional approaches to asset allocation tend to focus on asset

classes, but many of these asset classes are highly correlated because
they contain similar risks. For example, US and Japanese equities are
often considered to be different asset classes but, in reality, they are
highly correlated, especially after adjusting for currency risk. Consequently, optimisation techniques become unstable, as each asset class
is a perfect substitute for another, apart from return assumptions. In
other words, small differences in return expectations substantially
change the outcome of the optimisation.
Factors, on the other hand, can be designed to be nearly orthogonal, and often have a more stable correlation structure than
asset classes. Taborsky and Page (2010) illustrate this through a
simulation where asset-class cross-correlation is compared with
cross-correlation of factors during turbulent and quiet market
regimes. Correlations of asset classes were higher during turbulent market regimes, whereas factor correlations tended to exhibit
lower correlation under both regimes separately, and also for the
complete data sample.
Factor-based analysis can also diagnose the source of surplus
volatility more precisely. In many cases, the equity risk premium
plays a larger role in pension plan surplus volatility than would
be anticipated from looking at market values of each asset class
alone. Expanding on the pension plan example presented earlier,
the following three factors are chosen for the risk decomposition.
1. An equity risk factor: the total return of the S&P 500 index will
be used a proxy.
2. A (swap-like) duration risk factor, representing sensitivity to
nominal interest rates: the total return volatility per unit duration of the Barclays Capital 10-year Swap Bellwether Index will
be used as a proxy.
3. A corporate risk factor: the excess return of the Barclays Capital
Corporate Index over comparable maturity Treasuries will be
used as a proxy.
Using these factors, we can disaggregate each of the asset classes
into factor exposures. Inflation risk is not explicitly considered at this
stage, but it will be discussed in detail in the next section. The results
from regressing asset-class returns versus risk factors are shown
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Table 17.10 Risk factor loadings by asset class

Equities

Coefficients t -stat.
Intercept
Duration risk
Corporate risk
Equity risk (S&P 500)
0.0
0.0
0.0
1.0
R2
N/A
N/A
N/A
N/A
N/A
Fixed income

Intercept
Duration risk
Corporate risk
0.0
3.8
0.3
N/A
R2
0.9
10.6
56.5
16.8
N/A
Alternatives

Intercept
Duration risk
Corporate risk
0.0
0.9
0.5
0.2
R2
0.4
4.0
1.9
4.0
6.8
Liabilities

Intercept
Duration risk
Corporate risk
0.0
7.9
1.1
N/A
R2
0.9
0.6
33.3
21.0
N/A
Since both the equity asset class and the equity risk factor are defined by
the S&P 500, the factor loading is 1.0. Duration risk is expressed as unit
of volatility per year of duration. Hence, the coefficient value approximates
the duration of the asset.
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Table 17.11 Risk factor loadings for the pension funds surplus
Assets and
liabilities
Equities
Fixed income
Overlay
Alternatives
Liabilities
Surplus
Weight (%)
Risk factor loadings

Equity
24
60
60
16
111
11
1.0
0.0
0.0
0.2
0.0
0.3
Duration
0.0
3.8
8.7
0.9
7.9
1.2
Corporate
0.0
0.3
0.0
0.5
1.1
1.0
Table 17.12 Risk factor correlation matrix

Equity
1.0
0.1
0.5
Duration
0.1
1.0
0.3
Corporate
0.5
0.3
1.0
in Table 17.10. Note that the intercepts are, in most cases, statistically indistinguishable from zero. The swap overlay is not shown in
Table 17.10, since, by virtue of our choice of factors, it will have a
non-zero loading to duration risk only, as displayed in Table 17.11.
Based on the risk factor loadings and the weights of assets and liabilities, we can assess the factor exposures of the pension fund surplus
(Table 17.11).
After deriving the covariance matrix for the three factors (Table
17.12), we calculate the overall volatility of the surplus,11 as well as
the variance decomposition and risk contribution from each factor
(Table 17.13). The variance decomposition by factor offers a unified
approach to examining the underlying risks within each asset class
as well as in the overall portfolio or pension fund surplus.
Most notably, the corporate spread risk factor now plays a prominent role, highlighting the mismatch between the asset side (where
the Barclays Capital Aggregate Index used as a proxy contains limited corporate exposure) and the liability side, where the large factor
loading arises from the corporate curve used for discounting. As a
result, the surplus benefits from a widening in credit spreads. This
is also the reason why the duration loading of the surplus at 1.2 is
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Table 17.13 Variance decomposition by risk factor and factor-model

surplus volatility
Risk factor
Equity
Duration
Corporate
Total
Factor-model surplus volatility
Loading
0.3
1.2
1.0
Variance
decomposition (%)
47
3
50
100
4
less in absolute value than that found when analysing risk by asset
class, as the negative duration is now split between the (swap-like)
duration factor and the corporate risk factor.
Further insight comes from comparing the correlation structures
of asset classes versus risk factors. While equities and liabilities
were previously positively correlated (Table 17.7), risk factor analysis breaks this (as seen in Table 17.12) into a negative correlation
between equity risk and interest rate duration (ie, falling equity
prices often coincide with rising swap prices) and a positive correlation between equity returns and corporate bonds excess returns (ie,
equities drop when corporate bond prices fall in relation to treasury
bonds).
Risk factor analysis can provide considerable insight on the risk
and return drivers of any portfolio. As usual, the selection of factors
and the empirical data (or implicit views) used for estimation will
have an important effect on the covariance matrix and model outputs
and thus need to be scrutinised in detail.
MODELLING INFLATION IN A FACTOR FRAMEWORK
The factor framework is useful for modelling risk factors that influence the performance of several asset classes. Inflation is an example of such a factor. Factor or asset-class volatility models typically
use nominal returns and volatilities as inputs. Inflation is therefore
represented as a static expectation contributing to asset-class returns.
One approach to addressing inflation explicitly is to move from
the nominal to the real return space, which would include deriving
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Table 17.14 Excess inflation: summary statistics for total sample

(19472011)
Mean (%)
t-statistic
Observations
0.3
1.5
2.2
129
Excess inflation is equal to the annualised realised inflation (over a

semester) minus the surveys median from the previous semester. The
t-statistics indicate that the sample mean is statistically different from zero.
an inflation-adjusted covariance matrix. This may pose some computational issues, as inflation data is published with a lag and less
frequently than market prices, which can be observed in real time.
Moreover, this may limit the ability to rely on third-party vendors for
market return data series, as these are almost invariably calculated
in nominal terms.
Another way to go about this is to include a new variable: unanticipated or excess inflation, which would represent inflation in excess of
any actuarial assumptions. According to the Fisher equation (Equation 17.1), most asset classes embed some level of expected inflation iEXP in their price; in other words, their market value is derived
by discounting future cashflows using a nominal curve. Since both
actuarial projections (used for cashflow projections) and nominal
discount curves already include an inflation assumption, the only
remaining issue for pension plans is the effect of excess inflation over
the relevant (typically long-term) time horizon. In practice, things
are not so simple, as market prices (ie, discount curves) adjust in
real time, while the actuarial assumptions used to estimate future
liabilities cashflows do not.
With the advent of the inflation-linked bond market, we have
a market-based measure of expected inflation (for different tenors
across the term structure), also known as break-even inflation.
For example, the 10-year US Treasury Inflation-Protected Securities (TIPS) break-even, a measure of long-term inflation expectations, has ranged from 0.1% to 2.7% (Figure 17.2). One drawback of
these market-based measures is the short history of the data series,
which, in particular, does not contain any period of high inflation
(US TIPS were first issued in 1997). In addition, there is evidence
of a substantial liquidity premium affecting break-even inflation in
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Figure 17.2 Break-even Inflation for the 10-year US TIPS

3.0
2.5
2.0
% 1.5
1.0
Jan 4, 2011
Jan 4, 2010
Jan 4, 2009
Jan 4, 2008
Jan 4, 2007
Jan 4, 2006
Jan 4, 2005
Jan 4, 2004
Jan 4, 2003
Jan 4, 2002
Jan 4, 2001
Jan 4, 2000
Jan 4, 1999
0.5
Source: Bloomberg.
the US, at least for the first few years since first issuance (because
of this, inflation break-evens are likely to underestimate inflation
expectations in at least part of the period considered).
It is possible to extend these market-based time series back in time
for more meaningful historical comparisons, although the methods used to do this will introduce their own bias. One option is to
use information from publicly available inflation surveys (although
these surveys typically poll expectations over a short time horizon:
six months in the following analysis).
In Tables 17.14 and 17.15, we look at the excess inflation series
derived as the difference between actual realised inflation rates and
inflation expectations. The latter are measured by the median of
the Livingston Survey (specifically, the median of the semi-annual
survey is used as an estimate of inflation expectations for the next
six months).12
It should be noted that the data shows two very different periods:
during 1947 to 1974, the surveyed economists persistently underestimated inflation (on average by 0.5%), whereas between 1975 and
2011, economists persistently overestimated inflation (on average
by 0.9%).
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Table 17.15 Excess inflation: subsamples summary statistics

Sample
19471974
19752011
Mean (%)
0.5
1.5
0.9
t-statistic
2.3
6.0
Observations
57
72
1.3
Table 17.16 Factor volatilities and correlation matrix

Annualised
Excess
volatility (%) Equity Duration Corporate inflation
Equity
Duration
Corporate
Excess inflation
16
1
4
1
0.1
0.5
0.1
0.1
0.4
1
0.3
0.5
0.3
0.1
1
0.2
0.2
1
0.4
Adding excess inflation to the factor model described earlier,13 we

derive the correlation and volatility estimates shown in Table 17.16.
In order to estimate the factor exposures, we need to determine
the relationship between the inflation factor and the pension plans
assets and liabilities. To this end, we use the concept of inflation
duration. In the previous pension plan example, 60% of benefits
cashflows were explicitly linked to consumer price changes. In practice, this means that liability valuations will depend on cashflow
estimates based on actuarial assumptions of long-term inflation.
Whether an inflation surprise today will cause a change in longterm inflation expectations, and thus actuarial assumptions and/
or long-term discount rates, will be a function of several factors. If
the inflationary surprise turns out to be a one-time event, expectations may stay anchored, and the consequent impact on actuarial
assumptions, long-term discount rates and the value of liabilities
may be limited. A study by Grkaynack et al (2006), found that, in
the US, the relationship between an inflation surprise and change in
long-term expectations was mostly relevant when the surprise was
large.
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Table 17.17 Risk factor loadings and variance decomposition
Loading
Equity
Duration
Corporate
Excess inflation
Variance
decomposition (%)
0.3
0.8
1.5
0.8
42
1
46
13
Total
100
Regressing the excess inflation series against changes in 10year nominal Treasury yields (as a measure of long-term inflation
expectations),14 we find that a 1% inflation surprise moves the 10year nominal yield by 10 basis points. In other words, the excess
inflation factor loading (as a percentage of assets) is equal to the
product of
the regression coefficient (+0.1) linking short-term survey
expectations of inflation to long-term actuarial assumptions

for inflation,
the duration of the share of liabilities whose cashflows are
linked to inflation, ie, 60% 12.7 = 7.6 years,
the liabilities weight as a percentage of assets, ie, 111%.
In detail
excess inflation factor loading = 111% 0.1 60% 12.7
= 0.8
Our convention for the sign should be interpreted as implying a

decrease in the surplus as a result of an increase in inflation.
Next, the total variance of the pension fund can be decomposed
into the four risk factors, one representing excess inflation. The
results are shown in Table 17.17 (cf. Table 17.13).
Inflation may indeed become an issue for pension funds. From
the standpoint of risk budgeting, inflation may not rank as high as
other risks in the plan; most pension plans have large exposure to
equity risk. However, inflation risk, and relevant hedging strategies,
should be explicitly analysed, especially if a material percentage of
liabilities, but few or no assets, are indexed to inflation (similarly to
our example).
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Finally, variance-based models, such as the one described here,

may underestimate the impact of tail events, especially if the latter
are not represented in the historical data set. Indeed, mitigating the
risk of such events should be a critical consideration, often more
important than trying to hedge against small and less consequential
changes in inflation.
INVESTMENT STRATEGIES
Unlike liability-matching strategies employing nominal interest
rates, where instruments are widely available, finding matching
assets for unanticipated inflation is not straightforward. Many assets
provide compensation for anticipated inflation (eg, nominal bonds),
but few have explicit hedging properties against unanticipated
(excess) inflation. With the exception of instruments that are contractually linked to inflation, most other assets include a substantial
amount of basis risk. In the following, we shall consider the different asset classes that are most commonly thought of as having
inflation-hedging characteristics. These include
government-issued inflation-linked bonds,
inflation derivatives,
public and private real estate, as well as other real assets,
commodities,
equities.
One of the challenges for the inflation market has always been
that few natural sellers of inflation-hedging instruments exist, while
demand for inflation assets is definitely growing. In Mercer Consulting (2011), 80% of pension plans in Europe view inflation as a
major concern. The predominant investment vehicles for these plans
are inflation-linked bonds (18% of respondents), followed by other
investments, such as commodities and real estate (12%). European
plans on average hold 39% in real estate, depending on the size
of the plan. In comparison, the average plan has only 1.8% in commodities, with only 7.5% of European funds investing in this asset
class.
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Table 17.18 Government-issued inflation-linked bonds in selected

countries
Country
Outstanding notional
(US$ bn)
Issuance in 2010
(US$ bn)
213
146
62
21
568
260
55
28
30
28
21
15
0
92
50
0
1
2
1,384
209
France
Italy
Germany
Greece
US
UK
Japan
Sweden
Canada
Total
Entries have been rounded.

Source: BNP Paribas.
Government issued inflation-linked bonds

Inflation-linked bonds are issued by many developed countries (see
Table 17.18 for a snapshot of major markets), as well as several
emerging market countries. At the time of writing, the outstanding
stock of developed market issuance is approximately US$1.4 trillion.
Compared with the size of total government bond markets in these
countries, inflation-linked bonds represent only 6% of total notional.
In essence, while Treasury inflation-linked bonds are ideal hedging
instruments, the existing stock is likely to be too small to satisfy
demand, especially if concerns about inflation become widespread.
In addition, inflation-linked bonds have, from time to time, carried
negative real yields, which may be the result of scarcity of issuance.
Using instruments with negative real yields to hedge liabilities may
be too expensive, since there is no certainty that inflation will rise
to levels where it would endanger the solvency of a pension plan.
Another challenge for pension funds is that inflation sensitivity of
inflation-linked bonds is typically related to overall consumer prices,
whereas pension liabilities tend to have specific sensitivity to wage
inflation.
Use of inflation-linked bonds in pension funds is widespread;
however, each country has differing levels of adoption. In the US,
the largest holders have traditionally been mutual funds, rather than
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pension funds; state and other public pension funds have been the
largest pension investors, given their direct indexation of liabilities.
In continental Europe, one of the potentially largest markets is the
Dutch pension market, given that their existing inflation-linked liabilities remain largely unhedged. In the UK, where inflation-linked
bonds are well established, approximately one-third of the existing
stock is held by pension funds, and another third is held by insurance companies (Barclays Capital 2010). Trends in pension buyouts
in the early 2000s have also increased demand, as buyers of liabilities
seek to hedge their exposures.
Inflation derivatives
Inflation derivatives can offer more tailored protection against inflation. The market has grown rapidly, especially in Europe, and has
matured over time. The inflation derivatives market can be divided
into three basic instruments:
1. inflation futures;
2. inflation swaps;
3. inflation options (such as caps and floors).
Futures markets in inflation have struggled around the globe. In
the US, the most recent attempt was the CPI-linked futures contract
launched in 2004, which subsequently ceased to trade given the lack
of demand.15 The European Harmonised Index of Consumer Prices
(HICP) futures are traded at both the Chicago Mercantile Exchange
(CME) and the Eurex, but volumes have been virtually non-existent
between 2009 and the time of writing.
The swap and option markets, on the other hand, have flourished.
In the US, there has been demand for inflation total-return swaps,
and option volumes have been rising substantially (Figure 17.3).
Because of their customisable nature, inflation derivatives probably
hold the greatest promise for the pension industry.
Option strategies could also turn out to be the most efficient way
to hedge against tail risks in inflation. Traditional tail-risk hedging strategies such as out-of-the-money equity puts, collars and
put-spread collars can now be implemented using inflation options
instead. It should be noted that some of these strategies can get
very complex and, given the relatively recent introduction of inflation derivatives, for most institutional investors they may require a
reliance on outside expertise.
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Figure 17.3 Number of inflation options traded in the US
Inflation options (thousands)
7,225
7
6
5
4
3
2
1,365
1
0
460
2008
2009
2010
Source: BNP Paribas.
A rising inflation environment is likely to boost the appeal of these

strategies, albeit the inherent complexities hinder their widespread
adoption. These growing pains are similar to those experienced in
the credit default derivatives market, which began in obscurity but
has subsequently become an integral, if at times controversial, part
of the derivatives market.
Public and private real estate and other real assets
Public and private real estate are often considered real assets, and
therefore expected to perform well during periods of unanticipated
inflation. Most real estate investments by pension funds take the
form of either listed real estate (eg, Real Estate Investment Trusts
(REITs)), or private real estate funds. Given that REITs trade on stock
exchanges and resemble listed equities, they tend to have a relatively
high correlation with equity investments. For example, in the period
from March 1981 to March 2011, US REITs had a correlation of 55%
with the S&P 500 index, and a correlation as high as 74% with the
Russell 2000 value (NAREIT 2011).
Fama and Schwert (1977) found that private real estate is the only
asset that provides protection against unanticipated inflation. The
experience in 2008 in both the residential and commercial real estate
markets demonstrated, however, that this asset class is susceptible to
periodic over- and under-valuation (Figure 17.4). In addition, private
real estate investments tend to be illiquid, which creates challenges,
particularly for plans that are nearing the end of their life cycle.
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Figure 17.4 US residential home prices versus consumer prices

25
CaseSchiller
CPI-U
20
15
10
5
% 0
5
10
15
25
Jan 1988
Jan 1989
Jan 1990
Jan 1991
Jan 1992
Jan 1993
Jan 1994
Jan 1995
Jan 1996
Jan 1997
Jan 1998
Jan 1999
Jan 2000
Jan 2001
Jan 2002
Jan 2003
Jan 2004
Jan 2005
Jan 2006
Jan 2007
Jan 2008
Jan 2009
Jan 2010
20
Source: S&P CaseShiller Indexes, Bureau of Labor Statistics.
Rebalancing the portfolio, for example, may be nearly impossible if

private real estate assets make up a large part of a pension funds
assets.
While most countries do not have specific limits on investments
in real estate for pension funds (OECD Secretariat 2009), their allocations have tended to be relatively small. In the Netherlands, overall
allocation to real estate is less than 1.3% for the pension sector (De
Nederlandsche Bank 2010); comparable figures are 6% in the UK
(Kutsch and Lizieri 2005) and 1.2% in the US16 . In some countries,
investments in real estate are part of most pension funds; for example, real estate makes up between 5% and 10% of total assets in
Switzerland, Portugal, Finland, Canada and Australia (OECD 2011).
Commodities
Commodities are considered to be one of the natural hedges against
inflation. Commodity markets are large and liquid, with annual trading volume of the 24 commodities in the S&P Goldman Sachs Commodity Index (GSCI) totalling over US$56 trillion (Standard & Poors
2011). While physical commodities are cumbersome to trade, store
and transport, financial contracts linked to commodity prices are
widely available in the form of futures, swaps, options, exchangetraded funds and structured notes. Since most market participants
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do not typically hold physical commodities, investment returns

are different from changes in spot prices. Specifically, Greer (2000)
divides the return of the commodities futures into the following
components:
the real rate of return;
expected inflation;
unexpected inflation;
producers insurance premium;
rebalancing yield.
As can be seen from this decomposition, excess or unanticipated

inflation can be considered part of the commodity contract return.
Commodities should therefore function as an effective hedge against
inflation surprises. Greer found that, using asset-class data from 1970
to 1999, correlation of commodities to changes in inflation was as
high as 57%, whereas both stocks and bonds exhibited a similar level
of negative correlation (53% and 51%, respectively). Commodity prices are also one of the typical causes of cost-push inflation,
and therefore should be an effective hedge for tail risks like the oil
embargo in the 1970s.
The challenge for pension plans arises from the fact that, in addition to inflation, commodity prices are also influenced by many other
factors. Long-run S&P GSCI monthly data from 1970 to 2011 suggests
that annualised commodity returns (measured by changes in spot
rates) were 4.8% on average, compared with a sample average annualised inflation rate of 4.4%. However, using an even longer data set,
commodity returns were in fact sharply negative over the 20th century, declining up to 50% against consumer prices during the same
period (Reserve Bank of Australia 2007). The underperformance in
commodity prices was driven by many factors, including improvement in extraction techniques, discoveries of new sources of energy
commodities and enhancements in agricultural productivity. However, some believe that, with the rapid growth of the worlds population, in particular in the emerging markets countries, commodities
are entering a period of secular rise. For example, Grantham (2011)
identifies 24 commodities that are at least two standard deviations
away from their previous declining trend.
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Data suggests that commodity investments by pension funds are

quite small. While some prominent investors have entered the market, most pension plans do not have allocations to commodities. In
the US in 2007, the California Public Employees Retirement System
(CalPERS) had 3% of its US$207 billion of assets in commodities;
Hermes, in the UK, and Algemeen Burgerlijk Pensioenfonds (ABP),
in the Netherlands, had similar allocations (Doyle et al 2007). A survey of managers by Towers Watson (2010) suggests that the top 100
alternatives managers combined only managed US$20 billion for
pension fund clients. Given that global pension assets amount to
about US$26 trillion at the time of writing, this indicates that most
pension funds do not have meaningful exposure to commodities as
an asset class.
Equities
Equities are held as an investment by most pension plans. Globally, in 2011, 47% of total pensions assets were in equity investments
(Towers Watson 2011). The objective for equity investments is typically to provide higher returns, at the cost of increased surplus
volatility. Historically, the equity risk premium, or return above the
risk-free rate, has been on average (geometric mean measured over
Treasury bills) 5.8% (Dimson et al 2002, p. 165).
In addition to the attractive returns, allocation to equities has also
traditionally been considered a (partial) hedge against inflation. Rising prices should, in theory, filter into rising revenues for corporations and therefore provide a natural hedge against inflation. In practice, however, companies are often unable to pass rising raw material
prices on to consumers directly, resulting in erosion of profit margins
(Bulthaupt 2004). An example of this dynamic can be found in the
relationship between equity prices and inflation during the 1970s,
when high inflation was concurrent with poor equity performance
(Figure 17.5).
Since the 1970s, significant empirical evidence has accumulated
against the efficacy of stocks as inflation hedges. Bodie (1976), for
example, concludes that if stocks have inflation-hedging properties, they actually appear to contradict what is commonly thought;
therefore, to use them as a hedge would require going short.
Lastly, equities are likely to have poor hedging properties against
inflation tail risks. A large, unexpected increase in inflation will not
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Figure 17.5 US stock performance and consumer prices in the 1970s

50
S&P 500
CPI-U
40
30
20
10
Dec 1, 1969
Jun 1, 1970
Dec 1, 1970
Jun 1, 1971
Dec 1, 1971
Jun 1, 1972
Dec 1, 1972
Jun 1, 1973
Dec 1, 1973
Jun 1, 1974
Dec 1, 1974
Jun 1, 1975
Dec 1, 1975
Jun 1, 1976
Dec 1, 1976
Jun 1, 1977
Dec 1, 1977
Jun 1, 1978
Dec 1, 1978
Jun 1, 1979
Dec 1, 1979
Source: Bloomberg.
only put pressure on earnings but also create uncertainties, and thus
increase the equity risk premium, setting the stage for poor equity
performance.
However, it should be noted that, while equities as an asset
class are not an effective inflation hedge, there may be specific
equity sectors with better inflation-hedging properties. Examples
could include commodity producers, such as gold mines, or essential utilities, such as sewer and electricity generators. Investors
could conceivably create baskets of equity securities in multiple
inflation-sensitive industries, in order to reduce business cycle
effects.
CONCLUSIONS
Whether inflation is a material risk for a pension plan is largely determined by its specific circumstances. The hedging of nominal liabilities, which has been a substantial trend in the industry since the mid
2000s, has relied on the easily identifiable duration gap between
assets and liabilities. Analysing inflation sensitivity of the plans in
the same way is much more difficult, given the complexities associated with both actuarial assumptions and the estimation of the
inflation sensitivity of the underlying investments.
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Considering hedges for inflation risk makes sense, but, given the
intrinsic uncertainty associated with estimating the sensitivity to
inflation, a partial hedge might be a more practical trade-off. Furthermore, the hedge instruments directly linked to inflation, such
as inflation-linked bonds or derivatives, can often be costly, as there
are few natural sellers of inflation protection. For others, basis risk
can be substantial. The latter, however, can be mitigated by diversification, ie, by employing several of the inflation-hedging strategies
at once as a way of reducing the idiosyncratic risk arising from each
asset class.
Lastly, pension plans should be concerned about inflation tail risk.
While the implications of moderate inflation are not dire to either
the plan sponsors or the pension beneficiaries, substantial and protracted inflation, similar to that experienced in the 1970s, could have
a large negative influence on pension funds solvency ratios and their
ability to meet their obligations.
1
The plan sponsor is the entity establishing the pension programme. It might be a State or local
government entity, or a private corporation.
Effectively the 20th century, although some central banks did come into existence earlier than
this.
Surplus is equal to the market value of assets minus the market value of liabilities.
For example, the US Generally Accepted Accounting Principles (GAAP) and the International
Accounting Standards (IAS).
See, for example, the discussion on UK public pension discount practices in Ralfe (2011).
For a detailed study on relationship of wage growth and price inflation, see, for example,
Hess and Schweitzer (2000).
Annually in the US and once every three years in the UK.
While the pension plan data used here for illustration is based on an actual plan, we have
made many simplifying assumptions. In the actual case, asset classes are represented with a
higher degree of granularity and the relationship between the plans liability and inflation is
substantially more complex. We have used proxy benchmarks to represent both assets and
liabilities in the illustrative calculations. The size of the pension fund liability is changed to
US$1 billion for illustrative purposes.
Of course, we might pick a different pair of variables (nominal rates and inflation, or nominal
rates and real rates). For example, in the section discussing the modelling of inflation in a factor
framework (page 406), we shall work with nominal rate duration (swap rates discounting)
and inflation.
10 Duration estimates for the indexes are based on information from Barclays Capital as of
March 31, 2011.
11 This volatility turns out to equal 4% of the asset value per annum, or about US$36 million
per year. It should be noted that, given the more granular approach, the liability risk appears
slightly smaller than that using the asset-class-based approach. This is an illustration of how
different covariance matrices may lead to shifts in relative contributions, and overall risk, in
different models.
12 See http://www.philadelphiafed.org/ for details on this inflation survey.
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13 Data used to estimate factor correlation and volatility for the equity, duration and corporate
spread factors represents a shorter period than that used for excess inflation. We have used
monthly data from January 1994 to the end of December 2010 for the overall factor model,
and augmented it with excess inflation using semi-annual data from January 1972 to the end
of December 2010.
14 We could have used the 10-year US TIPS inflation break-even instead. We elected to use the
nominal Treasury yield in order to avoid the issues with limited data and technical liquidity
distortions in the US TIPS market.
15 Previous attempts to establish the inflation futures include, for example, the CPI futures
launched in 1985 by New Yorks Coffee, Sugar and Cocoa Exchange.
16 See OECD Global Pension Statistics data at http://www.oecd.org/daf/pensions/gps.
REFERENCES
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Capital Inflation-Linked Research, March.
Bodie, Z., 1976, Common Stocks as a Hedge against Inflation, The Journal of Finance 31(2)
pp. 45970.
Bulthaupt, F., 2004, Inflation and Equity Prices, Economy & Markets, Dresdner Bank,
Report 07-08/2004.
Davis, E. P., 2000, Regulation of Private Pensions: A Case Study of the UK, Discussion
Paper PI-0009, The Pensions Institute, July, p. 20, URL: http://www.ephilipdavis.com/
wp0009.pdf.
De Nederlandsche Bank, 2010, Macro-Economische Statistiek Pensioenfondsen, Q4/
2010, URL: http://www.statistics.dnb.nl/popup.cgi?/usr/statistics/excel/t8.1nk.xls.
Dimson, E., P. Marsh and M. Staunton, 2002, Triumph of the Optimists: 101 Years of Global
Investment Returns (Princeton University Press).
Doyle, E., J. Hill and I. Jack, 2007, Growth in Commodity Investment: Risks and Challenges for Commodity Market Participants, FSA Markets Infrastructure Department,
March.
Durevall, D., 1998, Inertial Inflation, Indexation and Price Stickiness: Evidence from
Brazil, Working Papers in Economics, No. 8, School of Economics and Commercial Law,
Goteborg University.
Fama, E., and W. Schwert, 1977, Asset Returns and Inflation, Journal of Financial
Economics 5, pp. 11546.
Fischer, D., 1996, The Great Wave (Oxford University Press).
Fisher, I., 1930, The Theory of Interest: As Determined by Impatience to Spend Income and
Opportunity to Invest It (Philadelphia, PA: Porcupine Press, Reprint, 1977).
Grantham, J., 2011, Time to Wake Up: Days of Abundant Resources and Falling Prices
Are Over Forever, GMO Quarterly Letter, April.
Greer, R., 2000, The Nature of Commodity Index Returns, The Journal of Alternative
Investments, Summer, pp. 4553.
Grkaynack, R., A. Levin and E. Swanson, 2006, Does Inflation Targeting Anchor LongRun Inflation Expectation? Evidence from Long-Run Bond Yields in the US, UK, and
Sweden, Federal Reserve Bank of San Francisco Working Paper 2006-09.
Halonen, D., 2010, Fed: US Corporate Plan Assets Up 3.8% in Q4, Pensions and
Investments, March 11.
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Hess, G. D., and M. E. Schweitzer, 2000, Does Wage Inflation Cause Price Inflation?,
Federal Reserve Board of Cleveland, Policy Discussion Paper 1, April.
Kutsch, N., and C. Lizieri, 2005, The UK Pension Industry: A Research Report for the
Pension Real Estate Association, University of Reading Business School, December.
Litterman, B., and The Quantitative Resources Group, 2003, Modern Investment Management: An Equilibrium Approach (Hoboken, NJ: John Wiley & Sons).
Mercer Consulting, 2011, Asset Allocation Survey: European Institutional Market Place
Overview 2011, Report, May.
Mitchell, O., 2000, New Trends in Pension Benefit and Retirement Provisions, Pension
Research Council Working Paper (PRC WP 2000-1).
NAREIT, 2011, REITWatch: A Monthly Statistical Report on the Real Estate Investment
Trust Industry, National Association of Real Estate Investment Trusts, April.
Nazmi, N., 1996, Economic Policy and Stabilization in Latin America (New York: M. E. Sharpe).
OECD, 2007, Global Pension Statistics 2007, URL: http://www.oecd.org.
OECD, 2011, Pensions at a Glance 2011: Retirement-Income Systems in OECD 180 and
G20 Countries, Report.
OECD Secretariat, 2009, Survey of Investment Regulation of Pension Funds, URL:
http://www.oecd.org/dataoecd/30/34/2401405.pdf.
Pensions Protection Fund, 2010, The Purple Book 2010, The Pensions Regulator and
Pensions Protection Fund.
Pettee, E. W., 1936, Long-Term Commodity Price Forecasting 1850 to 1930, The Journal
of Business of the University of Chicago 9(2), p. 97.
Piggott, J., and R. Sane, 2009, Indexing Pensions, Report, The World Bank.
Ralfe, J., 2011, The Correct Pension Discount Rate, Financial Times, March 13.
Reserve Bank of Australia, 2007, The Recent Rise in Commodity Prices: A Long-Run
Perspective, Reserve Bank of Australia Bulletin, April.
Rockoff, H., 1984, Drastic Measures: History of Wage and Price Controls in the United States
(Cambridge University Press).
Schmitt, D. G., 1984, Postretirement Increases under Private Pension Plans, Bureau of
Labor Statistics 107(9), p. 3.
Scitovsky, T., 1979, Home Truths about Inflation, in Essays in Post-Keynesian Inflation,
pp. 2830 (Cambride, MA: Ballinger).
Shlaes, A., 2007, The Forgotten Man: A New History of the Great Depression (New York:
HarperCollins).
Siegel, L., and M. Waring, 2004, TIPS, the Dual Duration, and the Pension Plan, Financial
Analysts Journal 60(5), pp. 5264.
Standard & Poors, 2011, Commodities 101: Understanding Commodities and S&P GSCI, S&P
Indexes Practice Essentials Series, Standard & Poors Research.
Taborsky, M., and S. Page, 2010, The Myth of Diversification: Risk Factors vs Asset
Classes, PIMCO Viewpoints, September.
Towers Watson, 2010, Global Alternatives Survey, Towers Watson and the Financial
Times, June.
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Towers Watson, 2011, Global Pension Asset Study 2011, Towers Watson and the Financial
Times, February.
Weinstein, H., 1997, Post-Retirement Pension Increases, in Compensation and Working
Conditions, Bureau of Labor Statistics, Fall, p. 49.
Yermo, J., 2007, Reforming the Valuation and Funding of Pension Promises: Are Occupational Pension Plans Safer?, OECD Working Papers on Insurance and Private Pensions,
No. 13.
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18
Ultra-High-Net-Worth Investors and

the Real Asset Value Chain
Ian Barnard
Capital Generation Partners
Ultra-high-net-worth (UHNW) investors and their families are a

diverse group of investors, more variegated than the investment
institutions that aggregate the investable assets of the majority of
citizens. But, at the same time, they have investment objectives and
practices that overlap with those of investment institutions. They
too seek to protect their portfolios from inflation. Indeed, they may
pay more attention to the risk of inflation, which is reflected in
widespread ownership of real assets, including particularly, but not
exclusively, real estate.
UHNW investors face a perceived inflation sensitivity that is
arguably more acute than that which confronts many investment
institutions. To start with, their time horizon is inter-generational,
thus longer than is typical for inflation-sensitive institutions such
as, for example, pension funds. Moreover, they believe that their
expected and realised inflation is higher than that of the average
consumer; their liabilities go up in price at a higher rate than that
measured by consumer inflation, as we shall show in the following.
And, what is more, the perceived cost of protecting against inflation is higher because they have an absolute real-return investment
objective, which means that meeting inflation is simply not enough.
UHNW investors take many steps to deal with this problem, but
a common theme is the extensive use of investments in real assets,
rather than inflation-linked financial instruments, in their portfolios.
Moreover, there are a couple of strategies often employed in order to
meet both the inflation and the real absolute return objective. One is
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the willingness to invest at an early stage in the real-asset value chain.

The other is the use of financial leverage. It is UHNW investors, and
their real-asset strategies, that we explore in this chapter.
THE ULTRA-HIGH NET-WORTH INVESTOR
What defines the UHNW investor is the scale of their investable
assets. There is little agreement on where this category begins, but
a useful figure is a sum in excess of US$500 million. It is not the
case, though, that UHNW investors are homogeneous. There are
differences. For example, when it comes to return expectations,
some remain in the get rich frame of mind that generated their
wealth. Others have moved to a stay rich mindset. Moreover, there
is often a generational divide. First-generation wealth is, perforce,
likely to be concentrated in fewer hands, and meeting the liabilities of fewer beneficiaries. Personality effects are evident, too,
particularly if the first generation remains in control of the capital.
Older wealth will likely have a more dispersed group of beneficiaries, which may, but not always, have developed more structure,
in part to diminish or manage the influence of personality. All this
contrasts with the investment institutions, whose numerous beneficiaries are actuarially transformed into a relatively homogeneous
profile of liabilities.
THE INFLATION THREAT
Where UHNW investors converge again is in their concern about
actual inflation, which is commonly held to be higher than consumer
inflation. And inflation, much more than deflation, is the historic
enemy of private wealth. Many historic fortunes have dissipated
because the beneficiaries underestimated inflation. They took dividends, which they believed were paid from real returns, but, because
they underestimated inflation, the dividends were paid from nominal return only and ate into the real value of their capital. Moreover,
there are few allies in voicing the reality of inflation for the wealthy.
Public authorities try to minimise it, in order to control it. Investment
professionals can increase their perceived real-return outcomes by
minimising the inflation they deduct from nominal returns. But the
fact is that the liabilities of the UHNW investor differ from those of
the general consumer.
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ULTRA-HIGH-NET-WORTH INVESTORS AND THE REAL ASSET VALUE CHAIN
By contrast, deflation is less of a threat to UHNW investors. They

are, at root, a rentier class with, by definition, extensive financial
assets. They therefore have extensive deflation protection inherent
in their portfolios. While some wealthy families were harmed by
deflationary periods, such as the Great Depression, it is inflation
that remains the principal concern of this group.
LEGACY AND TIME HORIZON
Investment institutions are engaged in intra-generational wealth
management, ie, spreading capital across the lifetime of their beneficiaries. A pension or life assurance policy trades consumption now
for consumption in the future. But with capital so far in excess of
need, UHNW investors face an inter-generational question of legacy:
what will be left behind? In some cases, the legacy will be devoted
to the support of children and subsequent generations. In addition,
there is often extensive planning of philanthropic projects, in particular the endowment of educational institutions, for the purposes
of teaching, new buildings or scholarships. But the key point is the
very long-term nature of this capital, with a horizon spanning several
generations.
LIABILITIES
The liabilities of the ultra wealthy fall into two areas: staff, and other
consumption services and goods. Both are perceived to inflate more
rapidly than headline consumer prices. For example, the wealthy
consume large volumes of services delivered by a diverse set of
staff. These include domestic services, education, entertainment and
investment managers, to name a few. Pay inflation is reckoned to
inflate with nominal GDP, although in some Western countries the
aggregate data is not compelling in this respect. But inflation of
the high-end service sector has certainly been above average inflation for the typical basket. One example is financial services, where
specialist staffs have seen incomes rise dramatically, to the point
where professionals in this sector are becoming HNW investors
themselves.
In addition, education is an important liability for rich families.
They have to educate their children and, as mentioned before, they
have also been great historic supporters of educational philanthropy.
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Figure 18.1 US Higher Education Price Index compared to CPI

300
US HEPI
US CPI
250
200
150
100
50
0
1961 1966 1971 1976 1981 1986 1991 1996 2001 2006
Sources: HEPI, July 1June 30 data (Research Associates of Washington and
Commonfund Institute). CPI data (US Department of Labor) is calculated to July 1
June 30 (annual published CPI is computed over the calendar 12-month period).
Based at 100 in 1983.
Figure 18.2 Colliers International Luxury Residential Index compared

to CPI
US CPI
Colliers International Luxury Residential Price Index peak
350
300
250
200
150
100
50
0
Mar
2000
Sep
2001
Mar
2003
Sep
2004
Mar
2006
Sep
2007
Mar
2009
Sep
2010
Sources: Colliers International, Hong Kong; US Department of Labor; indexes

based 100 in March 2000.
Figure 18.1 shows the US Higher Education Price Index compared

to Consumer Price Index (CPI).
The wealthy consume scarce consumption goods, such as homes
in fashionable areas, art, fine wine and other collectibles. The inflation in these products is high. The explanation is the path dependency embedded in luxury products. The newly created wealthy
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Figure 18.3 Liv-ex Fine Wine Index against CPI

400
350
300
250
200
150
100
50
0
Jul
2001
Liv-ex Fine Wine 100 Index
Oct
2002
Jan
2004
Apr
2005
US CPI
Jul
2006
Oct
2007
Jan
2009
Apr
2010
Sources: Liv-ex Limited (production and supply weighted), US Department of

Labor; both indexes based at 100, in January 2004.
Figure 18.4 Art Market Research indexes versus inflation

1,400
1,200
1,000
800
Art Market Research Old Masters Index 100

Art Market Research Modern Art Index 100
US CPI
600
400
200
0
Jan
1985
Apr
1988
Jul
1991
Oct
1994
Jan
1998
Apr
2001
Jul
2004
Oct
2007
Jan
2011
Sources: Art Market Research, US Department of Labor; based at 100 in January

1985. Note: art indexes based on median top 25% of prices named in sector.
compete to own products and goods that are perceived to be of the

highest quality, whether because of location, workmanship or historic importance. Indeed, a motivator for wealth creation is to be
able to consume such things. Figure 18.2 shows the Colliers International Luxury Residential Index against CPI starting from 2000.
Figure 18.3 shows the Liv-ex Fine Wine index against CPI from 2001.
Finally, Figure 18.4 compares two art market indexes against inflation. The take-away message from all three charts is clear: in recent
years, luxury goods and services have risen faster than the average
basket price inflation.
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REAL ASSETS
The perceived realities of UHNW inflation are a simple explanation
why consumer-inflation-linked securities do not provide an inflation solution. With the low real yields that characterised the 2008
global financial crisis and are still predominant at the time of writing in 2011,1 such an investor is, in practice, bearing negative real
returns. Additionally, wealthy investors have an absolute return target profile, ie, an asymmetrical return target of inflation or more.
In comparison, investment institutions have traditionally tended to
have a more symmetrical benchmark approach. Behavioural finance
has shown if, indeed, it was ever in doubt that investors have
a natural bias against loss: they find losses more painful than gains
pleasurable. Since UHNW investors are less intermediated than the
beneficiaries of institutions, their preferences carry through more
clearly to the market. Of course, the fact that absolute returns are
desired does not mean that they are readily available, but UHNW
investors themselves provide the backdrop and the capital for the
financing and generation of new opportunities for absolute return
investments.
It is exactly the wish to own inflation-protected assets with reasonably high returns that sheds light on the historically material allocation to real assets within UHNW portfolios: particularly real estate,
but also agriculture and forestry.2 Good-quality hard assets, in the
right location, with stable inflation-exposed cashflows (be they core
real estate, infrastructure, power plants or even forestry) are attractive for many investment portfolios. Historically, the 69% nominal
returns on these investments have translated into real, unleveraged
returns in the 46% range (once adjusted by consumer inflation). But
even for real assets, returns have decreased over time, partly because
of increasing institutional investors demand. Hence, two strategies
have been employed by UHNW investors in order to retain inflation
protection while generating target returns: developing real assets
from an early stage and using leverage.
Part, of course, of the return available from very early-stage investment is a premium for illiquidity, which wealthy investors have
historically been willing to receive. Their long, inter-generational,
time horizon makes them natural buy-and-hold or buy-and-wait
investors.
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When it comes to determining allocations to real assets, UHNW

investors have at their disposal all the tools available to investment
institutions. As noted above, this is a variegated pool of investors,
and different investors have different approaches to portfolio construction or asset allocation. In many cases, it is a target percentage
of assets. It can be low, but is typically in excess of 20% and, in some
cases, over 75% of investable assets.
When it comes to measuring success, practice again varies. There
are hard measures of real (after inflation) investment performance.
But, in other cases, performance is measured by reference to generating a target income without great concern for appraised value.
Finally, there is the fact that performance is not measured but, rather,
investors are satisfied by the existence of real assets in their portfolios
in the belief that they provide strong protection against unexpected
inflation or events.
THE REAL-ASSET LIFE CYCLE
Before looking more closely at the benefits, and risks, of engaging
in development, it is worth summarising the real-asset life cycle,
which, conceptually at least, looks similar across different types of
underlying asset. The start is project development; then there is construction or implementation, commissioning and, finally, operation
(Figure 18.5). To take them in reverse, the outcome of the development of a real asset be it commercial real estate, forestry or a windfarm is a hard asset that generates a running yield. There are, of
course, some differences among real assets. For example, the product be it accommodation for office staff, wheat or electrical power
can be sold on short-term or long-term contracts. In addition, the
price may be spot market or long-term fixed-price offtake. Different industries have distinct prevailing models. For example, central
London core commercial property is long-let, with often upwardonly rent reviews; forest products can be sold spot or into forward
markets. But the crucial point is that the outcomes are relatively
tightly defined: you produce commodities and receive an income,
which offers some inflation protection.
We divide the pre-operational phase into commissioning, construction and project development, although these all come under
the umbrella of development, ie, the business of producing an
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Figure 18.5 The real-asset life cycle and value chain

Project
development
Construction
Commissioning
Operation
operating real asset. The stage immediately prior to operation is commissioning: letting a completed, or soon-to-be completed, property
or switching on a wind farm. Forestry fits less tidily, but commercial
thinning (getting the forest ready for harvest) is analogous. Construction or planting precedes and typically represents the largest
single item of cost to create the asset. Construction of real estate,
erection of wind turbines, building roads and planting trees are all
capital-intensive activities.
Project development can be hugely value accretive, and commensurately risky. At the outset, it involves having the idea to create a real
asset, ie, producing a winning concept, and then securing the three
necessary ingredients for successful development. The first one is to
secure use of the land. At the outset, a developer might take an option
but, in the end, before beginning construction, will want to have the
absolute right to use the land in the way they need. Next are plans
and permissions: a building, or likewise an energy-producing asset,
needs detailed plans from concept design to detailed construction
drawings. And, in most cases, public authority permissions are also
required. The final element of the triumvirate is finance. Figure 18.5
gives a conceptual illustration of this value chain.
RISKS AND RETURNS
At the final stages of the value chain, the owner largely bears the
market risk of the asset, with the expectation that there is inflation
protection. Take the example of real estate. If an investor has developed a core office property, they will let it into the market for office
space. There is some idiosyncrasy around building quality and location, but its impact will be relatively small in relation to the prevailing rents in the area. In the case of real assets that produce fungible
commoditised outputs, such as energy or timber, there is scope for
trading, but the price is very largely market determined.
As you move to the beginning of the value chain, the risk is more
idiosyncratic, and the expected return is generally higher. Taking the
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three basic building blocks, the risks offer different types of return
at each stage. Most isolated from broader macro factors is the design
process. A clever, beautiful or efficient design is a purely idiosyncratic (ie, not correlated to market factors) source of return. This is
evident in real estate projects, as well as in decisions about the layout
of a timberland plantation, a wind farm, or solar park.
As for acquiring land, development land is most often priced by
residual value calculations. That is, you determine what the final
product, such as an office building, will be worth; you then deduct
costs, including financing, and a profit for the developer, usually
expressed as a percentage of costs, before arriving at the residual
value for the land. This leaves the value of land exposed to the current assessment of discounted future value of the end product. Of
course, this exposure to macro risks embeds some inflation sensitivity: if the price of real estate rises, land values will increase to reflect
this. And, as noted above, it exposes the residual value of the land
to the availability of finance: low discount rates both reduce financing costs and increase the discounted future value of the completed
asset. Consequently, the price of development land can be wildly
volatile through the cycle.
When it comes to permits, public authority permissions are largely
independent of market risk. In fact, public authority decisions relate
to policy and the wishes of their electorate, be it national, regional
or municipal. These should be largely uncorrelated to broader economic factors. Indeed, achieving preliminary, and then final, public
authority permits is highly value accretive, but also risky in a relatively binary fashion. A refusal to approve a new shopping centre is
hard to mitigate by means other than simply appealing. The extent
to which this development stage is dependent on broader macro factors lies in the possibility that, because of hard economic times, for
example, a public authority might restrict a building permit in order
to avoid undermining existing asset values.
Finally, the availability of finance is most closely correlated to
broader macro factors. In times of capital plenty, more projects are
financeable. In harder times, securing capital might generate more
return. Experience suggests that the benefits of capital plenty are
only fleetingly captured by developers and that after an interval the
surplus thus created seeps to other parts of the industry, often the
landowners.
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Return (%)
Figure 18.6 Risks and returns along the real asset value chain
25
10
8
6
Development risk
Construction risk
Commissioning risk
Inflation and beta
Financed
and permitted
Construction
completion
Operational
start-up
Liquidity capital deployment
Figure 18.6 illustrates the changing nature of the risks borne at

different points in the value chain and a rough indication of unleveraged expected real returns.
The model of investing at different stages along the value chain
encompasses several assets, with real estate being one of the most
commonly sponsored by private investors. In fact, it is not an accident that a proportion of any countrys rich list will contain families who made, and sustained, their fortunes through real estate
investment. But other real assets, in addition to real estate, have also
attracted UHNW investors interest. One example is the emerging
sector of renewable energy, where the inflation protection embedded in the core asset, coupled with attractive real rates of return,
has secured increasing amounts of capital from a large number of
private investors.
LEVERAGE
In order to meet their dual objectives of inflation protection and
attractive real returns, private wealthy investors often use leverage, as borrowers, and they do so with awareness of the differences
between leveraging an asset at an early stage (say, pre-construction)
and leveraging an operating asset with on-going cashflows. In the
case of early-stage leverage, the expected return is substantially
enhanced, although this grow rich investment strategy comes at
the price of much higher operational and financial risk. When a
development project is financed at a later stage, operational risk
is diminished along returns, but financial leverage still provides a
boost to this stay rich strategy.
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Return (%)
Figure 18.7 Leverage along the real asset value chain
25
Development risk
+5%
10 Construction risk
8 Commissioning risk
6
+2%
+1%
Inflation and beta

Financed
and permitted
Construction
completion
Operational
start-up
Liquidity capital deployment
In addition to the point of development at which leverage is

employed, the investment strategies described above might differ by
the extent to which the lenders security extends beyond the underlying asset. The more conservative approach is to borrow money
secured against the asset only. In this way, only the equity in the
project is at risk, should there be a problem along the way. By contrast, borrowing that extends beyond the asset is more get rich.
This might be a guarantee from a holding company relying on additional collateral, or directly from the beneficial owner. Or, there might
be cross-collateralisation with other assets. The get rich path is evidently taken in order to achieve terms of leverage that are unavailable on the stay rich path. This get rich path might be to increase
the levels of leverage, or to secure any leverage at all, particularly
against development assets, the future cashflows of which are contingent on events outside the control of the sponsor. Figure 18.7 is
a stylised illustration of how the application of leverage enhances
returns along the value chain.
In addition to enhancing returns, UHNW investors sometimes
give an additional rationale for applying leverage to real assets,
which is to benefit from inflation. They judge that inflation will
reduce the real value of the debt, thus increasing the real value of the
remaining equity. The effect will be more pronounced if the project
is financed by long-term fixed-rate debt. Clearly embedded in this
view is the assumption that the cashflows of the underlying asset
will also increase with inflation, so its value will not decrease despite
a rise in discount rates.
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In this discussion of leverage, the UHNW investor has been

the borrower rather than the lender. There is the option for such
investors to lend into real-asset structures and this occurs. Of course,
as discussed above, lending at an earlier stage of the real-asset development process has equity-like characteristics. But, in general, experience suggests that such investors opt to be at the lower end of the
capital structure and look to other participants to provide the senior
tranches, be they banks or investment institutions.
CONCLUSIONS
In this chapter, we discussed UHNW investors peculiar investment
characteristics, in particular their long-term horizon, typically spanning several generations, and their sensitivity to inflation, which
goes beyond that measured by the average basket of goods and services. Next, we explored how UHNW investors pursue their dual
objectives of inflation protection and attractive real returns by investing at early stages of asset development projects, and judiciously
employing leverage along the way.
1
This is true of developed inflation-linked markets in particular.
UHNW investors allocations to mining and energy projects are harder to execute, given that
the size of capital required to develop these assets is typically very large.
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19
Inflation Markets: A Portfolio

Managers Perspective
New Sky Capital
Because general price levels affect asset returns and the economy as a whole, inflation is an important risk that every investor
should carefully analyse, and actively manage, in order to protect real wealth. In fact, the rationale for managing inflation risk
and for evaluating investments in real returnrisk space does not
need justification, as it is grounded in common sense. Instead, it
might seem surprising that virtually all commonly used investment metrics rely on nominal measures, which do not explicitly
capture the insidious impact of inflation on wealth. This cavalier attitude can be in part traced back to inflation-linked instruments (which are explicitly and formulaically indexed to inflation)
being a relatively recent innovation to fixed-income markets,1 combined with the intrinsic difficulty in assessing the correct dynamic
relationship between inflation sensitive assets (such as commodities, real estate, equity or infrastructure investments) and inflation
itself.
Besides being an important macroeconomic risk, inflation also
offers attractive opportunities to the active investor. Indeed, market inflation expectations displayed equity-like volatility during and
after the 20089 global crisis. This coincided with a substantial reduction in risk capacity on behalf of market makers, thus creating pricing
distortions and relative value opportunities due to supplydemand
shocks and hedging activities, in a market where liquidity can at
times be limited, despite the impressive growth since the tail end of
the crisis.
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The inflation market provides a risk-transfer mechanism between

investors and hedgers. In the first section, we explain how inflation markets work, the different economic agents involved and what
motivates them, as well as the role of market makers in providing liquidity. Next, we discuss the role of analytics, starting with top-down
macroeconomic models. After explaining some of the key characteristics of inflation as a time series, we introduce the expectationaugmented Phillips curve and present some structural equilibrium
relationships that can be helpful in modelling price indexes. Monetary policy models in the spirit of Taylors rule are also discussed,
as are the relationship between real rates and growth, and scenario analysis. We then cover bottom-up models, most of which
use market prices as inputs. We discuss how to extract real rates
from zero-coupon inflation swaps, the relationship between swap
and cash break-even inflation (BEI) rates and asset swap (ASW)
spreads, and the interplay of inflation expectations and risk premiums in determining inflation compensation. Next, we show how
to calculate carry for inflation-linked bonds, and discuss the issue
of seasonality. Finally, we briefly introduce the inflation option market and summarise the key assumptions and results of the seminal
JarrowYildirim pricing model.
After having geared up with the indispensable theoretical tools, in
the last section we deal with practical examples and considerations
that should be useful when investing in inflation products. After a
discussion of our holistic approach to the sector, which combines
both fundamental and technical information, we present two concrete strategy examples in detail: a directional BEI trade and an arbitrage trade relying on mispricing between the cash and derivative
BEI rate. A summary section concludes.
INFLATION MARKETS
Understanding inflation markets requires an appreciation of the
entire mechanism through which inflation risk is transferred. This
analysis can be quite complex, and several academic papers and
books have been written on the subject. In this section, we shall
focus on the main ideas, introduce the different agents active on the
supply and/or demand side of the inflation market, describe their
investment/hedging needs and behaviour, characterise the size of
flows and the role of governments and, finally, address whether the
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INFLATION MARKETS: A PORTFOLIO MANAGERS PERSPECTIVE
Table 19.1 Estimates of inflation supply and potential demand (in US

dollars)
Inflation supply/payers
Inflation demand/receivers
Size of global IL supply 2,750 bn Size of IL demand 4,300 bn
Sovereign IL Debt
(US, Canada,
Brazil, France,
Mexico, Italy,
France, Germany,
UK, Australia,
Japan)
2,500 bn Pension Funds IL

liabilities
Insurance
companies IL
liabilities
Infrastructure IL
debt (UK,
Australia,
Canada)
80 bn
Utility companies
IL debt (Europe,
Australia, Brazil)
90 bn
Commercial real
estate IL debt
(Europe,
Australia)
40 bn
IL mortgage debt
(Iceland, Chile,
Mexico, Brazil,
Israel)
<30 bn
1,800 bn
1,400 bn
Asset managers,
hedge funds IL
assets
700 bn
Sovereign funds,
central banks IL
assets
300 bn
IL savings
accounts
100 bn
Sources: Bloomberg, OECD, New Sky Capital.
inflation market is balanced overall, and can thus function as an

effective risk-transfer mechanism.
The different economic agents active in the inflation market can
be categorised according to whether their exposure is such that they
benefit from an unexpected increase in future inflation (so that they
are natural inflation payers), or the opposite is true (so that they
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Figure 19.1 The growth of sovereign inflation-linked debt

Developed countries
Emerging countries
2.0
1.5
1.0
0.5
0
Dec 1971
Dec 1973
Dec 1975
Dec 1977
Dec 1979
Dec 1981
Dec 1983
Dec 1985
Dec 1987
Dec 1989
Dec 1991
Dec 1993
Dec 1995
Dec 1997
Dec 1999
Dec 2001
Dec 2003
Dec 2005
Dec 2007
Dec 2009
Dec 2011
Inflation-linked debt (US$ trillion)
2.5
Sources: Bloomberg, New Sky Capital.
are natural inflation receivers). Inflation payers include economic

agents, such as central and local governments, whose revenue is
correlated to inflation and, to a lesser degree, corporate issuers, such
as utility and infrastructure companies. Inflation receivers, on the
other hand, are economic agents that are negatively impacted by an
unexpected increase in inflation, such as pension funds, insurance
companies and asset managers. Table 19.1 illustrates these points.
Inflation supply
As seen in Table 19.1, sovereign issuance is the major source of
inflation-linked bonds. Figure 19.1 shows the impressive growth
of inflation-linked sovereign bond markets in both developed and
emerging countries.
In the 1970s and 1980s, the issuers of inflation-linked debt were
typically governments in countries (especially in Latin America)
where high-inflation was common. The UK started issuance in 1981,
during a period of high inflation, embracing the rationale, first suggested by Keynes,2 that inflation-linked bonds would command
a premium from inflation-risk-averse investors. Indeed, funding
at attractive real yields remains one of the key motivations for
inflation-linked debt issuance.
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The sovereign inflation-linked debt market has increased dramatically to a size of almost US$2.5 trillion, with more and more
countries adopting a regular issuance schedule. This occurred over
a time when major economies experienced low, stable (or decreasing) inflation rates. In other words, it is not the risk of high inflation that has spurred interest in inflation-linked debt (and thus
promoted issuance) in the following two decades, but rather the
demand for a low-volatility investment asset, and effective portfolio
diversification.
However, with the increase in inflation volatility since the start of
the 20089 global financial crisis, new demand for inflation-linked
products has developed, with more investors taking an interest in
the space and its renewed opportunities. Incidentally, this demand
is likely to deepen the shortage of inflation supply (also shown in
Table 19.1), and thus provide good funding opportunities to natural
inflation payers, including non-sovereign issuers, particularly in the
infrastructure and utilities sectors.
Historically, the sourcing of inflation from non-sovereign issuers
has been limited, with the exception of the UK and, to some extent,
Australia (this is in line with pension fund hedging activity, which
is well developed in these two countries). However, as other markets evolve along similar paths, accounting/regulatory obstacles are
removed and assetliability management programmes encouraged,
we can expect non-sovereign issuers (whose financing needs we estimate to be about US$1.8 trillion globally) to progressively gain a
more prominent place among the global suppliers of inflation-linked
cashflows.
As for sovereign issuers, the context of large funding needs at the
time of writing points to a likely increase in inflation-linked bond
markets. However, governments will have to balance conventional
and real issuance, in order not to compromise the liquidity of their
nominal debt markets.
Inflation demand
Traditionally, pension funds have been the main driver of demand
for inflation products. This stems from the linkage of their liabilities to inflation, which can be either implicit (eg, taking the form of
annuities calculated from last salaries) or explicit (eg, in the form of
inflation-linked annuities, as in the UK). In some countries, such as
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the Netherlands, indexation can be conditional on pension funds

funding ratios. Pension funds demand was indeed a key driver of
governments issuing inflation-linked bonds. For example, in 1980,
the Wilson Report (Wilson Committee 1980) recommended that the
UK Government issue index-linked gilts specifically to meet pension
funds demand.
Insurance companies are the second larger driver of inflation
demand. Hedging inflation tail risk is of particular concern for the
property and casualty segment of the insurance industry. As insurance loss reserves calculations hinge on actuarial assumptions on
future inflation rates, the two decades from the 1980s to the time of
writing have been quite benign, as this period has seen an orderly
downwards trend in inflation rates in most developed markets, with
realised rates of inflation often lower than ex ante projections. However, we are now at a crossroads, at a time when it is not implausible
for future inflation rates to surprise on the upside. As a result, inflation companies have been more sensitive to the risk of inflation,
and more active in devising strategies to hedge it (sometimes in the
inflation option market).
Pension funds and insurance companies potential demand for
inflation-linked instruments is large, and is likely to grow even
larger, not only in developed countries but also in emerging countries, where demographics are supportive and financial markets
are evolving rapidly. Clearly, each specific market is at a different
stage of sophistication when it comes to the management of inflation risk, from simple awareness of such a risk factor, to quantitative
measurement and monitoring of sensitivities at the balance-sheet
level (through, for example, scenario analysis or Monte Carlo simulations), to proactive implementation of specific inflation-hedging
strategies on assets and/or liabilities. Indeed, the latter do have a
large influence on the market, especially in countries such as the
UK and in continental Europe, where pension funds and insurance
companies are very active players in the inflation sector. Interestingly enough, in the US, the demand for inflation products from
pension funds and insurance companies has been somewhat limited, which is probably a consequence of the successful anchoring
of inflation expectations from the 1980s onwards, thanks to effective monetary policy by the Feds. However, there is a growing concern that unconditional reliance on the central banks capacity to
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Table 19.2 Market impact of inflation hedging by pension funds and

insurance companies
Market impact
Currency
BEI
Real yield
ASW discount
Option
US dollars
Euro
Sterling
Medium
High
High
Medium
High
High
Medium
High
High
Medium
Medium
High
keep inflation under control might be misguided going forward,

and many institutional investors have focused more attention on
more challenging scenarios for the future.
Inflation-hedging strategies can be implemented on both the asset
side and the liability side of the balance sheet. We estimate that
about two-thirds of these strategies involve purchase of inflationlinked instruments as assets, while one-third involve the use of
inflation swap or option overlays on the liability side. Clearly, there
are trade-offs with both implementations. Inflation-linked bonds are
typically more liquid than swaps (higher volume traded; lower bid
ask spread). However, they have been plagued by credit issues in
Europe, and they have not performed well in risk-aversion episodes.
The use of inflation derivatives on the liability side is a pure inflation
play, but it has clear limitations in terms of market depth and liquidity, especially in the context of decreased risk appetite and inventory
from market makers offering these products.
The hedging activities of pension funds and insurance companies have several consequences. These are summarised in Table 19.2,
where we consider four market variables: swap BEI; real yields; asset
swap discount (the difference between linker and nominal ASW
spread, which measures the difference between cash and swap BEI);
inflation option volatility. First, as these players keep a watchful
eye on the level of inflation break-evens in relation to long-term
averages, they provide a powerful mean-reversion force in the market when BEIs are historically low. In other words, these hedging
activities (where present, eg, in the UK and mainland Europe) effectively provide a floor for swap BEI rates (not a cap, as these are
buy-and-hold strategies). They can also provide the backdrop for
divergence in swap versus cash BEI rates, as happened in autumn
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2008. Hedging activity on the asset side provides support to longterm real rates, typically resulting in a relatively flat curve. Finally,
option overlay strategies generally provide support to out-of-themoney cap or floor inflation volatility, with large buyers at times
producing clear distortions in the volatility smile.
These technical flow dynamics are very powerful and cannot be
ignored, as they clearly exert a strong influence on market pricing
in sector.
Asset managers, hedge funds and sovereign funds have also
entered the inflation market, with important investment allocations
in the space. This source of demand is also on the rise, as alpha opportunities arise in the new climate of higher volatility, and the necessity
for managing beta inflation risk (de facto embedded in many portfolio) is increasingly recognised. Most large asset managers are longonly unleveraged investors, typically with a long-term horizon, who
are looking at locking-in attractive real rates. Some of the large asset
managers and sovereign funds are also benchmark sensitive. Retail
investors also participate in the space, and might be an important
price driver in certain situations, eg, when a specific inflation-linked
security is rebalanced out of a benchmark, so that it is typically sold
from large institutional portfolios.
As Table 19.1 makes clear, the potential demand for inflation products is large and at the time of writing cannot be met by the current
stock of inflation-linked bonds, despite their tremendous growth in
recent years. It is likely that, over time, this demand will be a driver of
additional supply, from sovereign and non-sovereign issuers alike,
as well as a main force behind further developments in the inflation
derivatives market.
The role of market makers
The role of market makers in mediating inflation flows is very
important, and understanding their structural positions and hedging activities is crucial in order to understand price behaviour in this
market.
Historically, inflation market makers, ie, investment banks, have
been structurally short BEIs via swaps (mainly sold to pension
funds in Europe) and short inflation volatility (mainly as a result
of coupon floors embedded in structured notes sold to the retail
market in Europe). These positions, and the strategies employed by
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banks in hedging them, had enormous consequences on the market,

especially during the 20089 financial and liquidity crisis.
Pension funds have been, and still are, a major receiver of inflation in the market. This demand has been focused on swaps, as these
allow for better customisation than simply buying linkers and can
be used as an overlay with limited balance-sheet usage. Looking
at the size of pension funds inflation-linked liabilities (estimated
at about US$1.8 trillion in Table 19.1), it is clear that such demand
cannot be met simply by investment banks acting as match makers
between swap buyers and sellers. Indeed, there are no natural sellers
of inflation through swaps, although some attempts have been made
to structure funding transactions for infrastructure and real estate
projects, where inflation can be stripped from revenues and channelled into a back-to-back swap. Consequently, investment banks
have to hedge most of these short swap BEI positions by buying BEIs
in the cash market. This is also why the most liquid inflation swap is
the zero-coupon swap, whose cashflow format strongly resembles
the inflation-accruing notional in sovereign inflation-linked bonds
in the US and Europe.3 As with any hedging strategy, recycling inflation from the cash market into the swap market has residual basis
risks and additional costs, most notably the financing of cash BEIs
(ie, the difference in the repo rate paid to finance the long inflationlinked bond positions, and the reverse repo rate earned on the short
nominal bond positions). These costs and the risk involved can be
substantial, especially for long-tenor transactions, as well as being
subject to volatility and changes in market liquidity conditions.
As for volatility, until the 20089 financial crisis, investment banks
accumulated short inflation option positions through coupon floors
embedded in structured notes sold to the retail market in Europe.
These options were delta hedged by selling inflation swaps.
When the financial crisis hit in autumn 2008, economic activity
and energy prices plunged, and so did inflation BEIs. The impact of
deteriorating fundamentals was greatly amplified by liquidity and
technical effects. As financing sovereign linkers in the repo market became more and more difficult, they quickly become casualties of the rapid balance-sheet deleveraging that ensued. And as
BEIs moved lower, delta hedging of short inflation option positions,
moving into-the-money, added insult to injury. To put things into
perspective, bond prices collapsed to the point where the five-year
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Table 19.3 Break-even inflation versus Dow Jones Industrial Average

(2011) yearly range
US BEI (%)
DJIA (%)
Initial
Low
High
Range
2.60 = 100
11,671 = 100
17
4
12
10
29
14
US TIPS had positive nominal yield in the hypothetical scenario

of a replay of the Great Depression, which made us comfortable
positioning against this market view (Perrucci 2009).4
The structural (long linkers on repo; short inflation swaps) exposure on banks trading books also caused swap BEIs to widen relative to cash, as market makers tried to unwind these trades. In turn,
as banks eagerness to obtain term financing of long inflation BEIs
and volatility exposure grew, inflation asset swaps also widened
considerably.5 These pricing distortions provided those investors
who were able to spot them the opportunity of a lifetime.
Technical effects are important not only during a systemic crisis
but also in normal circumstances, as inflation markets are generally not as efficient as nominal rates markets. This is due, in part,
to a smaller number of players who often pursue similar investment objectives, and whose behaviour, or change in preferences,
can have a large and long-lasting impact on market prices and
liquidity.6 Furthermore, bond supply is concentrated around auction dates, while liquidity in the secondary market is limited by the
fact that many institutional players in the inflation market are buyand-hold investors with a medium-to-long-term horizon. Indeed,
in this market, it is not unusual for supply or demand shocks to
drive prices away from fundamental value, thus creating attractive
opportunities for the active investor.
The inflation market after the 20089 global crisis
Despite the impressive growth in the market in the first decade of
the 21st century (Figure 19.1), the effects just described remain very
relevant at the time of writing, and opportunities in the inflation
market abound.
One important factor driving investment opportunities is that
BEIs were quite volatile during the global crisis and remain so in
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Figure 19.2 Swap 10-year BEI in Europe and the US

3.5
3.0
2.5
2.0
1.5
1.0
US 10Y BEI
EU 10Y BEI
0.5
Jul
2004
Jul
2005
Jul
2006
Jul
2007
Jul
2008
Jul
2009
Jul
2010
Jul
2011
its wake. Indeed, looking beyond the extreme gyrations experienced in 20089, and taking 2011 as an example, BEI swung up,
and then down, in synchronised moves, within a range that is
quite wide (29%), and more than double that of an equity index
such as the Dow Jones Industrial Average (14%) (Table 19.3 and
Figure 19.2).
Another consequence of the crisis is increased awareness of inflation risk on banks trading books, which, combined with new global
financial regulations and higher capital requirements, resulted in
limited balance-sheet and risk capacity on behalf of market makers.
At the same time, demand for inflation cashflows by large institutional investors has, if anything, increased, due to high volatility
in the market and also as a result of new regulations that focus on
inflation risk in a more explicit way. For example, Solvency II sets
capital requirements for insurance companies at the balance-sheet
level; thus, the effect of inflation on assets and claims makes capital
requirement inflation dependent. Because of these factors, the ability
to provide liquidity and intermediation of inflation risk and flows
structurally has decreased after the crisis, while demand has actually increased. This, in turn, has provided attractive opportunities
to the active manager.
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INVESTING IN INFLATION PRODUCTS

While most people are familiar with nominal interest rate strategies,
we believe real rates and inflation are the new frontier in fixedincome relative-value investing. Indeed, inflation risk should be
actively managed, as it can generate substantial alpha, and do so
with limited risk and leverage.
The truth of the matter is that inflation is a relatively untapped
market, which has not reached full maturity, and where specialist
knowledge is still in short supply. Indeed, traditional asset managers
have focused most of their attention on index-replicating strategies, rather than active alpha, and there is often a lack of skills in
approaching opportunities, which results in relative value trades
being missed or implemented with sub-optimal timing. As we have
already pointed out, the secondary market for sovereign inflationlinked bonds is not as liquid as the nominal one, and thus supply tends to be concentrated around auction times. Furthermore,
demand can also be spotty but, at the same time, come in size, given
the herding behaviour of a number of large investors pursuing inflation beta strategies and compelled to replicate their benchmarks by
either their internal guidelines or financial regulations (such as is the
case for many insurance companies and pension funds). These factors are at the root of the structural positions held by market makers
and their hedging activities, and thus are key to pricing across the
cash and derivatives inflation markets. A 360 view of these dynamics is essential to capture opportunities in the space, as is a good
grasp of both visible and less visible inflation flows (for example,
swaps and options, or inflation structures in the over-the-counter
market).
Given the multitude of factors affecting the market, we believe
a holistic investment approach should be adopted in which fundamental and technical analyses are seen not as antagonistic, but as
complementary. Furthermore, although both macroeconomic models and market models are useful, focusing uniquely on equilibrium
relationships as a measure of long-term value has often been the reason why (self-defined) value investors have failed to achieve attractive risk-adjusted returns, and ultimately protect the very same value
they were trying to extract from the market in the first place.
In other words, trying to navigate this market with a fundamental
view of inflation only would be as dangerous as a skipper pointing
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their boat towards a lighthouse in the distance, with no regard for

the unmarked rocks and low waters that stand in the way. The lighthouse is indeed a helpful sight, but we had better stay alert and
adjust our route wisely if we want to get to harbour safely, or get
there at all.
As for analytics and their role, our view of the world is shaped
by a number of proprietary, internally developed quantitative models, but is ultimately based on experience and judgment. In other
words, models provide a framework, not a substitute, for thinking. We recognise that, in spite of its mathematical sophistication
and analytical complexity, market forecasting often has limited predictive power, and is by nature a conditional exercise (on inputs,
assumptions, scenarios, etc). In addition, when it comes to inflation,
political considerations may trump economical considerations, for
example, in regard to fiscal and monetary policy. Thus, the value
in our analytics comes not from any point forecast, but from the
discipline they instil in our thought process, by establishing the balance of risks, the latter being far more important to investment decisions. Furthermore, it is very important to understand how consensus views are formed, even when we might believe them to be
wrong, as those have a profound impact on the behaviour of market
participants such as asset managers, pension funds and insurance
companies, with these flows often driving relative value opportunities in the sector. Finally, such a common sense approach is important
in setting an internal risk culture where model error is understood as
an intrinsic and unavoidable aspect of modelling the complexities in
financial instruments and markets, and focus is shifted onto the real
issue, which, in this authors opinion, is human error and personal
accountability in the sensible use of models as exploratory tools.
When it comes to inflation, we look at both bottom-up and topdown models, different time horizons and both statistical and structural approaches. In the next section, we shall give a brief qualitative
introduction to these models, as a full technical discussion would be
beyond the scope of this chapter.
MACROECONOMIC MODELS
Empirically, inflation is a non-stationary stochastic process; this
implies that its mean and volatility change over time. These features
are clearly evident from visual inspection (Figure 19.3).
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Figure 19.3 Inflation is a non-stationary stochastic process

30
US
Germany
25
UK
20
15
10
Inflation (%)
Japan
5
0
1961
1971
1981
1991
2001
5
2011
The difference between stationary and non-stationary processes

is important in regression analysis, as non-stationarity violates
the assumptions upon which statistical inference is based. In fact,
consider the simple regression
Yt = a + bXt + t ,
t IIN[0, 2 ]
where the error terms are independently and identically distributed

normal (IIN) variables, with constant mean (equal to zero) and variance 2 . If Yt and Xt are non-stationary processes, generally a linear
combination of the two, such as
Yt a bXt
will also be non-stationary, thus violating the assumption that the
error terms are IIN. As a consequence, spurious results will arise
when regressing non-stationary processes. As many economic processes are naturally non-stationary (as they trend, often in nondeterministic ways, and have changing volatilities), methods have
been developed to transform non-stationary processes into stationary ones. These include de-trending, taking differences and
cointegration.
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A stochastic process is said to be integrated of order k, or I (k ),

if it needs to be differentiated k times to achieve stationarity. For
example, if Xt is I (1), then the first difference process will be
stationary
Xt I (1) = Xt = Xt Xt1 I (0)
Methods have been developed to test the order of integration of
stochastic processes. These include unit-root tests, such as the augmented DickeyFuller and PhillipsPerron statistics (Dickey and
Fuller 1981; Phillips and Perron 1988). Although stationarity might
be obtained by differencing a series, any potential relationship at
the level of the variables is lost. This is a problem, as many economic theories that we might wish to test, such as the Quantity of
Money Theory mentioned later in this chapter, are formulated as
equilibrium relationships among the level of the variables.
Another method that is used in working with non-stationary time
series is cointegration. Consider two stochastic processes Xt and Yt ,
both integrated of order d, ie, I (d). If there exists a linear combination
of the two integrated processes of lower order d p
Y t Xt I ( d p )
then the two processes are said to be cointegrated CI(d, p). Clearly, the linear combination is unique (up to a normalisation-multiplicative constant). Note that if there is a cointegrated relationship
between two I (1), then we can regress them together without differencing, as the residuals will be well behaved, and thus ordinary
statistical inference can be used
Yt , Xt CI(1, 1) = Yt Xt I (0)
An n 1 vector of I (1) stochastic processes Xt is said to be cointegrated of rank r if there are r < n linearly independent I (0) combination of the n variables or, in other words, if there exists an r n
cointegrating matrix , such that Xt is an r 1 vector of stationary
stochastic variables
Xt [n I (1) stochastic processes]
= Xt [r stationary linearly independent processes]
It is clear that if the matrix is a cointegrating matrix, for every nonsingular r r matrix M, then M will also be a cointegrating matrix.
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Finding an economically sensible normalisation for the cointegrating space is part of the analysis (fixing the r2 terms in the matrix M,
ie, imposing just-identifying conditions). Often the number of conditions imposed on the model to ensure economic interpretability is
greater than r2 , resulting in a restricted model with over-identifying
conditions that can be tested and estimated accordingly.
It is customary to model inflation using a vector autoregressive
model of order p, ie, VAR(p). This is an n-dimensional model in
which the level of a stochastic vector process Xt depends on p lagged
values of the same vector
X t = At +
p

Bk Xtk + t ,
t IIN[0, ]
k =1
with constant covariance matrix . Note that we can have both a constant intercept and possibly linear or higher-order terms in At . The
above equation can be estimated by the ordinary least-squares (OLS)
method and then residuals checked for the multivariate normality assumption. The link with the cointegration approach becomes
clear if we consider the Granger Representation Theorem (Engle et
al 1987), which states that, for I (1) variables, a VAR(p) model can
be converted to a model combining both levels and differences (a
cointegrated model), ie, a vector error correction model VEC(q) of
order q = p 1
dXt = Xt1 +
q

Bk dXtk + t
k =1
Clearly, the first term must contain the stochastic equilibrium relationships among levels, while the second term is stationary by definition of I (1). Methods have been developed to test the existence and
number of cointegration relationships, among which is the Johansen
(1991) method. The latter infers the cointegration rank r by testing
the number of eigenvalues that are statistically different from 0 in
the error-correction matrix of the cointegrated VAR model, then
conducts model estimation under the rank constraints. Note that the
rank test is based on simulated non-standard asymptotic distributions that depend on the form of the VEC model, and the deterministic terms in particular. Once the rank r has been determined, the
Johansen procedure gives the maximum likelihood estimate of the
unrestricted cointegrated r 1 vector Xt (up to a normalisation
matrix M).
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As an aside, note that we typically work with the logarithm of

the variables under consideration. In fact, the log transformation
has several advantages in that it ensures that the original variables
remain strictly positive, mitigates some common issues with level
variables (for example, level-dependent volatilities, a form of heteroscedasticity, thus often resulting in better behaved residuals) and it is
the natural choice, since the proportional equilibrium relationships
we expect among our variables (eg, the quantity of money equation)
will be turned into linear relationships among the log transformed
variables (and captured by the cointegrated vector).
We know that several macroeconomic factors influence inflation,
and their impact varies at different time horizons. These factors
include the following.
Economic activity, eg, as measured by the output gap, which
can be inferred through statistical techniques or a theoretical

based approach. We use the latter here and also in our real rate
and monetary policy models.
Inflation expectations, which can influence consumer be-
haviour and price-setting patterns and thus become a self-fulfilling prophecy.

Persistency, which is in great part determined by the credibility
(or lack thereof) of monetary policy, and makes reversion to

equilibrium levels faster (or slower).
Exogenous shocks, which can have either a temporary effect or
a more structural effect on the economy and prices (commodity or currency shocks, changes in productivity or competitive
landscape, etc). By definition, exogenous shocks cannot be predicted, but they can be simulated, which we do extensively
through scenario analysis.
In our view, a monetarist approach to inflation is complementary rather than competitive to an expectation-augmented Phillips
curve, so we do look at the link between inflation and money growth,
although we realise that, empirically, the relationship is weak for
time horizons shorter than two years. In fact, we use a combination
of the money equation, the expectation-augmented Phillips curve
and our proprietary version of the Taylor rule to try to establish a
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Figure 19.4 Macroeconomic models of inflation

Money
multiplier
Velocity
Money
equation
Shocks to the money supply

will influence inflation
expectations and the
long-term mean reversion
level of inflation
Expectation
augmented
Phillips
curve
Used for inflation forecasting

and conditional scenario
analysis
Money
aggregates
Output
gap
Supply shocks
Inflation
expectations
Output gap
Taylor
rule
Inflation gap
A proxy for US/EU monetary

policy and the path of the short
rates, which determines the
term structure of nominal and
real bonds
general landscape that can then be explored in detail through specific scenario analysis (see Figure 19.4 for the key inputs to these
models).
While a bottom-up approach is used to gain insight on likely
short-term inflation behaviour (and it might be applied in practice
when estimating carry in short-maturity linkers), a top-down structural approach is typically used to establish long-term trends, and
in scenario/response analysis.
Monetary policy models
The Taylor Rule, introduced in 1993 as a descriptive model of monetary policy in the USA, links the US Federal Reserve funds rate to
the real economy and inflation
Fed funds rate = + GAP output gap + DEFL deflatorGDP
New Skys descriptive model of monetary policy, while belonging
to the family of Taylor Rules models, is in fact a proprietary model,
which provides an edge to our investment process. In fact, while the
Taylor rule (Figure 19.5) misses the tightening cycle of the mid-1990s,
and later the extent of easing of the post-tech-bubble recession, with
our proprietary definition of output gap, we are able to achieve a far
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Figure 19.5 NSCs proprietary Taylor rule model

12
Fed funds rate
Taylor rule
New Sky
10
8
6
4
2
Jan 2010
Mar 2011
Nov 2008
Jul 2006
Sep 2007
May 2005
Jan 2003
Mar 2004
Nov 2001
Jul 1999
Sep 2000
May 1998
Jan 1996
Mar 1997
Nov 1994
Sep 1993
Jul 1992
Mar 1990
May 1991
Jan 1989
superior fit than the traditional approach. Our framework also sheds
light on why the Feds have seen the need for quantitative-easing
policies, as the current slack in capacity would call for a negative
Fed funds rate.
Granted we do not have control on how the Feds set short-term
rates, we do have a pretty decent grasp of how the process has
worked in the past 20 years or so. Note that, having a good descriptive model of monetary policy is quite useful, but reading the minds
of policymakers does not in any way address the adequacy of the
monetary policy process itself.
Growth and real rates
As discussed in Chapter 7, when it comes to the inflation-linked
bond market, the primary focus of both domestic and international
(non-leveraged) investors is the level of real yields. Therefore, it is
natural to compare real rates, as a market-determined measure of
investment growth, with other benchmarks of economic growth,
such as the rate of change in real GDP.
At New Sky, we look at the link between real yields and real GDP
(the latter being a proprietary blend of realised and potential growth
rates), with the understanding that this is an equilibrium structural
relationship, which cannot be used to gain insight on short-term
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Figure 19.6 Ten-year US TIPS real yields and real GDP growth
4.5
4.0
3.5
3.0
2.5
2.0
1.5
Ten-year real yield
0.5
Real GDP growth
1997 Q4
1998 Q2
1998 Q4
1999 Q2
1999 Q4
2000 Q2
2000 Q4
2001 Q2
2001 Q4
2002 Q2
2002 Q4
2003 Q2
2003 Q4
2004 Q2
2004 Q4
2005 Q2
2005 Q4
2006 Q2
2006 Q4
2007 Q2
2007 Q4
2008 Q2
2008 Q4
2009 Q2
2009 Q4
2010 Q2
2010 Q4
2011 Q2
1.0
Sources: Federal Reserve Bank of St Louis, New Sky Capital.
changes in inflation-linked bond prices (which vary daily), but only

to gain insight on lower frequency cyclical trends. In other words,
we should not conclude, as some have, that, because empirical correlation between real rates and growth is dubious at best, there is no
linkage between the two. The truth of the matter is that correlation is
not the right metric to measure structural relationships of this kind
(Figure 19.6).
Scenario analysis
As stated before, our focus is not on economic forecasting, as we
believe that forecasting is a fuzzy exercise, even with the perfect
model, given that many factors remain outside the control of the
forecaster. Therefore, we do not rely on a central macroeconomic
forecast to identify trade opportunities, but rather we analyse the
market (for example, inflation break-evens) in the context of a plausible distribution of future scenarios, supplemented by stress-testing.
As an example, in autumn 2008, when the market was pricing negative long-term inflation expectations, our emphasis was not on forecasting inflation for the following 10 years, but on establishing that
we could invest in US TIPS and achieve positive yield if a Great
Depression scenario were to materialise again.
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Table 19.4 A few examples of scenario analysis
Cause
Scenario
description
trigger
Relative
Historical Real to target
example growth inflation
Policy
Cost push
Oil prices
shock
US
1970s
Below
Above
Loose
Demand
pull
Increase
in demand
China
today
Above
Above
Loose
Japan
1990s
Brazil
early
1990s
Below
Below
Ineffective
Below
Above
Ineffective
Expectations Deflation
spiral
Money
Increase in
supply
money
supply
Beside the lessons learnt from previous historical examples of

inflation/deflation occurrences (Table 19.4), we also supplement
our analysis with ad hoc scenarios, which are relevant to current
conditions and underlying risks.
As explained in Chapter 1, an inflation scenario is not just a path
for inflation, as the underlying causes of inflation (first and second
columns in Table 19.3) are equally, if not more, important in determining the effect on asset prices. Some qualitative details on a costpush shock are given in the appendix on page 473. Scenario analysis
is not just a quantitative exercise, but is supplemented and guided
by qualitative reasoning. In the appendix on page 474, for example,
we discuss the balance of inflation risk in the US in the long term,
and why we believe there is potential for upside surprises but high
inflation is by no mean an inescapable outcome.
PRICING MODELS
Macroeconomic models provide insight on the world and plausible
trends in risk factors, but they need to be supplemented with models
that analyse how those same risk factors are priced in the market.
We shall review some pricing/market models in the following.
Inflation compensation in the swap and cash market
Inflation compensation, ie, inflation break-even rates, can be observed both in the inflation bond (cash) market and in the inflation
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Figure 19.7 US 10-year swap versus cash BEI spread

1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0
Jul
2004
Jul
2005
Jul
2006
Jul
2007
Jul
2008
Jul
2009
Jul
2010
Jul
2011
swap (derivatives) market. Although, from a fundamental point of

view, these two measures embed the same market expectations, technically they are not exactly the same. This is clear from a graph of
the spread between swap and cash BEI, which has typically been
positive (about 3040 basis points (bp) on the 10-year tenor; see
Figure 19.7).
The positive spread arises from several reasons. To start, there
is a difference in repo rates between inflation and nominal bonds.
In other words, it is more expensive to finance sovereign inflationlinked bonds relative to nominal ones, and the cash inflation BEI
includes a liquidity risk premium, in the notation of Chapter 10 (and
the appendix therein)
R
yt,TIPS
= yt, + Lt,
TIPS
yt,N yt,TIPS
= yt,N yt,R Lt,
= BEI
Because of the liquidity premium (and the deflation floor), zerocoupon real rates are not directly observable from TIPS. However,
they can be extracted from zero-coupon inflation swaps using a noarbitrage relationship, which is model independent. Suppose that, at
time t, the zero-coupon inflation swap with maturity T = t + N (that
is, N years from now), is quoted at a rate equal to KN,t . This means
that at time T the swap buyer will receive an amount equal to the
swap notional multiplied by the realised return on the price index,
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Figure 19.8 Zero-coupon inflation swap and cash hedging strategy

Inflation
ZC swap
Realised inflation
Market
maker
Pension
fund
Swap BEI
KN,t
TSY
reverse
repo
IL TSY
repo
Long ZC
IL TSY
yt,TIPS
yt,N
Short ZC
TSY
Net financing cost

rIL rTSY
Hedging strategy
in exchange for the amount (1 + KN,t )N 1 agreed upon today. This

implies that the floating and fixed legs of the inflation swap have
equal value at inception t
Q
Et
T
IT
exp
It
rsN ds
= Et
T
(1 + KN,t )N exp
rsN ds
The left-hand side is the price at time t of the zero-coupon real bond
maturing at T, while the right-hand side is a constant times the Tmaturity nominal zero-coupon bond price at time t
R
R
N
Pt,T
= exp[yt,T
(T t)] = (1 + KN,t )N Pt,T
R
Therefore, at each point in time t, the real term structure yt,T
can
be inferred from the term structure of inflation swaps and nominal
zero-coupon bonds.
The effect of the relative difference in liquidity and financing costs
between nominal and inflation-linked bonds can be illustrated by
considering how a zero-coupon inflation swap might be hedged
with a combination of a zero-coupon inflation-linked bond and a
zero-coupon nominal bond. In Figure 19.8, it can clearly be seen
that the difference in swap and TIPS BEI comes from the difference in repo/reverse repo costs between the inflation-linked and
the nominal treasury
IL
TSY
KN,t = BEISWAP = yt,N yt,TIPS
= BEITIPS +rIL rTSY
+r r
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Figure 19.9 Zero-coupon inflation swap and ASW hedging strategy

Inflation
ZC swap
Short IL
asset swap
Realised inflation
Pension
fund
Long TSY asset swap
yt,N
Libor + ASWTSY
Swap BEI
KN,t
Realised inflation
Market
maker
yt,TIPS
Swap
ctpty
Libor + ASWIL
Swap
counterparty
The effect of the liquidity premium can be material, especially

during market dislocations, and, as we shall see later, it can be the
source of relative value opportunities between the inflation cash
and derivatives markets. For example, in autumn 2008, cash BEI
strongly underperformed swap BEI. This was caused by liquidity
deterioration and balance-sheet deleveraging, and not by sovereign
credit issues (as nominal and inflation-linked asset swap spreads
also diverged, which they would not have done if the underlying
trigger had been a perceived credit deterioration of the US Treasury).
Specifically, during that time, the repo market for inflation-linked
bonds became severely disrupted and, as market makers looked into
sourcing long-term financing of inflation cashflows, linkers ASWs
also widened, while nominal treasury ASWs were not affected. In
fact, the zero-coupon inflation swap above can also be hedged by a
combination of a long nominal Treasury plus a short inflation-linked
ASW. Figure 19.9 illustrates this point, and also makes it clear that
BEISWAP = BEITIPS + ASWIL ASWTSY
Other sources of disparity between cash and swap BEI come from
the different convexity between zero-coupon swaps and couponbearing bonds (eg, for upwards-sloping inflation curves, zerocoupon BEIs are higher than par inflation BEI rates), and also from
differences in supply and demand between the cash and derivative markets, with BEIs typically higher, as swaps are the preferred
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inflation-hedging instrument for many end users, such as pension

funds.
Inflation compensation: expectation and risk premium
Inflation compensation, that is, BEI, is the sum of an inflation expectation term plus an inflation risk premium (see the appendix in Chapter 10 for details). For example, neglecting Jensens terms and differences in compounding, the10-year swap BEI rate can be written
as
1
N
R
Inf
BEISWAP
= yt,10
yt,10
= 10 EPt [It,10
] + IRPt,10
t,10
Clearly, changes in BEI are driven by both terms but it is useful to
try to separate the two, and analyse them separately, which can be
done in several ways. We might estimate the parameters of a termstructure model and then derive expected inflation within the model.
Alternatively, a forecasting model for inflation (for example, a vectorautoregressive model or a Phillips curve model) can be used. Next,
we might use publicly available inflation surveys, such as the Survey of Professional Forecasters (SPF), a quarterly survey, providing
expected inflation over one-year and ten-year terms (Figure 19.10).
Finally, a term-structure model could be used but fitted to inflation
survey data, in addition to nominal and real yields. Interestingly
enough, Ang et al (2008) and Chernov and Mueller (forthcoming)
find that surveys outperform other methods of inflation forecasting, although they have the drawback of being available only at low
frequency.
If we accept the qualitative features of the survey series shown in
Figure 19.10, the conclusion is that, in the US, long-term (10-year)
inflation expectations have been relatively stable since the late 1990s,
hovering around an annual rate of about 2.5%. This is likely to be the
result of the Feds having established credibility in maintaining low
and stable inflation, so that short-term shocks in the spot rate quickly
revert to equilibrium, anchoring long-term expectations. This is also
consistent with the flat term structure of inflation expectations found
by Ang (2008) and Adrian and Wu (2010). Of course, we are not taking the 2.5% level literally, as it is just one measure of expected inflation, but we believe the inflation risk premium to be a key dynamical driver over typical trading horizons. In other words, although
macroeconomic models of inflation are important to our view of
the world, such structural relationships are of somewhat limited
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Figure 19.10 Inflation expectations from the Survey of Professional

Forecasters
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0
1991
Q4
1Y
1994
Q4
10Y
1997
Q4
2000
Q4
2003
Q4
2006
Q4
2009
Q4
Sources: Federal Reserve Bank of Philadelphia, New Sky Capital.
usefulness when trading in the inflation market, unless we believe

long-term equilibrium levels will change materially (which clearly
would directly affect BEI rates).
As derived in the appendix to Chapter 10, the inflation risk premium depends on the correlation between the real pricing kernel
(which includes both real rates and the price of risk) and the price
index It . Specifically
IRPt,
where
= ln
1+

MtR+
1
= exp
2
MtR
t+
t
Ts s
MtR+ It
,
MtR I t+

It
R
P
Pt, Et
It+
COVPt
ds
t+
t
Ts
dBPs
t+
t
rsR
ds
Indeed, if such a correlation is zero, the inflation risk premium is also

zero, and we recover the Fisher equation. In general, the inflation
risk premium is positive if above (below) average inflation occurs
in states where real wealth is below (above) average, and vice versa.
Before the Great Recession of 20089, the inflation swap market displayed a consistently positive inflation risk premium; however, our
estimate of the latter has turned negative on more than one occasion
since then (Figure 19.11).
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Figure 19.11 An estimate of the 10-year inflation risk premium

0.8
0.6
0.4
0.2
0
%
0.2
0.4
0.6
0.8
1.0
Jan 2012
Jul 2011
Jan 2011
Jul 2010
Jan 2010
Jul 2008
Jan 2008
Jul 2007
Jan 2007
Jul 2006
Jan 2006
Jul 2005
Jul 2004
1.4
Jan 2005
1.2
This underlines the fact that the market might price inflation risk
quite differently depending on the overall environment and the balance in risk aversion between investors who prefer fixed real returns
and investors who prefer fixed nominal returns. Specifically, if the
market is focused on the risk of high inflation, then nominal securities will be penalised by a positive risk premium. On the contrary,
if the market is concerned about deflation, then the nominal bond
will benefit from being the better deflation hedge, and the inflation
risk premium will be negative. This observation also hints at the fact
that, although the price of risk is typically modelled as a Gaussian
variable in affine models, higher moments than variance (skewness,
ie, asymmetry in inflation risk, in particular) might be important in
order to model the inflation risk premium realistically (Garcia and
Werner 2010). In fact, although the variance in inflation expectations,
as measured by the SPF (which also publishes spreads in quartiles
of the future inflation distribution), has increased since the Great
Recession, it does not help to explain the dynamics of the inflation
risk premium or indeed the changes in sign. Unusual circumstances,
such as quantitative easing by the Feds and sovereign credit woes in
Europe, are likely to have contributed to the bipolar pricing of inflation risk from 2008 onwards, as well as to long periods of negative
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real rates and an increased correlation between BEI and the equity
market.
Carry calculations
Carry can be an important value metric especially for short maturity
linkers. To calculate carry, we have to specify a time horizon, a financing rate and, in the case of inflation-linked bonds, non-seasonally
adjusted inflation rate projections over the relevant time window (so
that linkers carry inherits the index seasonality as well, which will
be discussed in the next section). A precise carry calculation should
take into consideration coupon income received and reinvested over
the period, the passage of time, yield roll-down, financing costs and
inflation accrual for the linker. However, given that these calculation
typically apply to short-term horizons and yet uncertainty about
future inflation rates supersedes concerns of mathematical precision, we shall use a simplified formula to guide intuition and write
the bond carry over a horizon of n = 1, 2, 3 months as
n
12
n

n
CPIk
CTIPS (n) = (yTIPS rTIPS ) +
12 k =1 12
CTSY (n) = (yTSY rTSY )
where CPIk is the non-seasonally adjusted consumer price index

inflation rate in month k. When comparing a nominal treasury with
the TIPS, we are implicitly assuming a similar roll-down on both
(that is, a locally flat BEI curve). In addition, we can derive the repoadjusted BEI rate as
BEIrepoadj = BEI +rTIPS rTSY
It can be seen that when the inflation projection matches the
repo-adjusted BEI (which occurs over the three-month horizon in
Table 19.5), the nominal and inflation-linked bonds have equal carry.
Further details are shown in Table 19.5.
Seasonality
In general, when analysing inflation opportunities over a specific
time horizon, we should try to determine a plausible distribution
of total returns over the chosen holding period. In the case of
an inflation-linked bond, total return includes interim cashflows
received (a function of fixed coupon and inflation), quoted price
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Table 19.5 Simplified carry calculation: BEI and repo-adjusted BEI
10yr nominal Tsy (%)

10yr TIPS (%)
Coupon Yield
BEI
Repo Repo-adj. BEI
2.000
1.83
0.125 0.35
2.18
0.20
0.30
2.28
1-month 2-month 3-month

NSA CPI projections (%)
Cum. annualised (%)
0.21
2.5
0.46
4.0
0.10
2.28
1-month 2-month 3-month

carry
carry
carry
1M Nominal Tsy carry (%)
1M inflation-linked carry (%)
Difference (%)
0.14
0.16
0.27
0.56
0.41
0.41
0.02
0.29
0.00
Figure 19.12 The effect of seasonality on US CPI rates in 2011

0.5
0.4
0.3
0.2
% 0.1
0
0.1
0.2
0.3
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Sources: US Bureau of Labor Statistics, New Sky Capital.
changes (a function of real rates and time) and interim inflation

accrual on notional (a function of realised inflation) as well as
financing costs.
Short-term inflation projections are particularly important in calculating returns for short-maturity linkers, since inflation accrual
on notional is usually the key determinant of value in these cases.
Clearly, given that, in the US, the inflation index used for notional
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Table 19.6 Market-based BEI and forecast-based BE yield

Yield
BEI
Duration
US Tsy (%)
0.30
US TIPS (%) 1.50
1.80
BEI
Next NSA CPI
BE yield
0.15
0.60
0.23
Monthly (%)
accrual is not seasonally adjusted, projections need to take into consideration all the seasonal fluctuations, which is not always an easy
thing to do. Indeed, while inflation and real rate changes are often
(but not always) positively correlated and tend to mitigate the risk of
longer maturity linkers, short-term fluctuations in realised inflation
due to seasonal patterns (or non-core volatile components) are very
important to the value assessment of short-term linkers. In addition, seasonal fluctuations cannot be ignored, as their size can, in
certain months, overwhelm other fundamental considerations (see,
for example, the magnitude of the seasonality effect for March in
Figure 19.12). Clearly, non-seasonally adjusted (NSA) price levels
are the only directly observable quantities. The reason to identify
seasonality factors explicitly stems from the desire to forecast NSA
series (which will in general contain trend, cyclical, irregular and
seasonal components) by extracting the regular predictable patters
(ie, seasonality) first, and then focus on the rest.
Consider a two-year (remaining maturity) linker with BEI equal
to 1.8%, which corresponds to an inflation accrual on notional of
about 1.8%/12 = 0.15% per month. Even assuming the market has
got the annual inflation rate correct, in any given month inflation
will fluctuate because of seasonality, and potentially other factors
as well. In other words, monthly inflation rates might still compound to give an effective annual 1.8% rate but are likely to have
a wigglier pattern, mirroring the seasonality factors shown in Figure 19.12 (which sum to zero). Specifically, suppose that there are
reasons (seasonality being one of them) to believe that, next month,
NSA inflation will come in at a 0.60% rate (this is about equal to
the monthly BEI rate plus the seasonality adjustment for March in
Figure 19.12). This implies that the two-year duration linkers yield
can widen 45/2 = 22.5bp before it underperforms the corresponding
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Figure 19.13 Inflation options implied volatility surface

2.5
2.0
1.5
%
1.0
0.5
11
16
21
Maturity
26
High strike
6
At-the-money
Low strike
maturity nominal (Table 19.6). Clearly if the NSA inflation forecast

and BEI coincide, the BE yield is zero.
Besides short-term carry, seasonality also plays a part in the analysis of relative value of longer-term inflation-linked bonds paying
coupons in different months.
Inflation option models
Inflation option quotes are regularly available for both caps and
floors (eg, on Bloomberg, see the screen shots in Chapter 8), but the
market has limited depth, and bidask spreads are material (as much
as a few percentage points of option premium). As a consequence,
market flows can be as important as (if not more than) fundamental
considerations when trading in the space.
There is no natural seller of inflation volatility, especially at high
strikes (ie, caps; inflation floors can be stripped from TIPS by ASWs).
The dealer community has traditionally provided volatility to end
users (either directly through inflation options or indirectly through
the inflation structured note market), while (delta-) hedging their
option book. Understanding this exposure, and its sensitivity to
changes in BEI, is essential, as it is a key driver of prices (the volatility smile often hints at these relationships, in addition to more
fundamental considerations such as the pricing of fat-tails, etc).
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Figure 19.14 Ratio of implied to realised inflation volatility

250
225
200
175
% 150
125
100
75
Aug 2009
Sep 2009
Oct 2009
Nov 2009
Dec 2009
Jan 2010
Feb 2010
Mar 2010
Apr 2010
May 2010
Jun 2010
Jul 2010
Aug 2010
Sep 2010
Oct 2010
Nov 2010
Dec 2010
Jan 2011
Feb 2011
Mar 2011
Apr 2011
50
Ten-year YoY 3% cap. Source: New Sky Capital.
Figure 19.13 shows the inflation implied volatility surface in May

2011.
The traditional buyers of inflation volatility are hedgers (eg, insurance companies), who have often limited sensitivity to price levels
and the difference between implied and realised volatility (shown
in Figure 19.14). In fact, given the technicalities, and the many analytical complexities, dynamical replication has not been a practical
avenue for these market participants.
There are several models used in pricing inflation derivatives.
Here we shall briefly introduce the first and seminal one, the Jarrow
Yildirim model, where the price index level is the translation mechanism between the money economy and the barter economy (see also
the appendix in Chapter 10, and Chapter 8). Specifically, in parallel
with the money economy, we can consider a barter economy where
contracts are specified in terms of a basket of good and services
R
(Figure 19.15). In other words, the zero-coupon bond Pt,T
(where T
is the maturity) in the barter economy promises one unit of the consumption basket at time T, in exchange for a fraction of the basket
today (assuming positive real rates, which should be the case unless
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Figure 19.15 The barter versus the money economy
Barter economy
Money economy
there are storage costs or a greater utility to later, rather than current,
consumption).
In the money economy, zero-coupon bonds denominated in basR
kets of goods, such as Pt,T
, are not tradeable instruments but their
US dollar value is (this is, in fact, our well known inflation-linked
bond, if one puts indexation lags and deflation floor aside). In other
words, to transition from the barter economy to the money economy, we need to multiply any basket-denominated quantity by the
price index It , which is denominated in US dollars per basket, thus
obtaining a dollar-denominated quantity.
Jarrow and Yildirim (2003) introduce three correlated Brownian
motions driving the stochastic dynamics of nominal and real instantaneous forward rates (so this model belongs to the HeathJarrow
Morton class), and the price level index It under the nominal data
probability P
R,N
T
Pt,T = exp
f R,N (t, u) du
f R,N (t, T ) = f R,N (0, T ) +
t
0
R,N (s, T ) ds +
t
0
R,N (s, T ) dBRs ,N,P
or, in differential form

R,N,P
dt f R,N (t, T ) = R,N (t, T ) dt + R,N (t, T ) dBt
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The price level index is given by

dIt
= tI dt + tI dBIP
t
It
It = I0 exp
R
NR
dBN
dt,
t dBt =
t
0
sI ds 2 tI2 +
t
0
sI dBIP
s
I
NI
dBN
t dBt = dt,
dBIt dBRt = RI dt
The forward rates volatility functions are chosen as in the Vasicek

(1977) model, that is
R,N R,N (T t)
R,N (t, T ) = 0
The fundamental tradeable instruments in the money economy are

N
the nominal zero-coupon bonds Pt,T
, the nominal money market
bond (our numeraire of choice)
BN
t
= exp
t
0
rsN ds
the dollar value of real zero-coupon bonds It Pt,R and the dollar
value of the barter economy numeraire It BRt . Therefore, to avoid
arbitrage, there should be a probability measure Q under which
all our tradeable assets, discounted by the nominal numeraire, are
martingales
N
Pt,T
It Pt,R It BRt
,
, N martingales under Q
BN
BN
Bt
t
t
Using the link between forward rates and bond prices and the
dynamics equations for rates and the inflation index, by using Its
formula, we can derive the stochastic differential equations for the
three quantities above. From these, the change in measure that eliminates drifts, thus taking us to the risk-neutral probability Q, can be
inferred.
In the risk-neutral measure Q, nominal and real zero-coupon bond
prices as well as the price index have a lognormal distribution
dIt
IQ
= (rtN rtR ) dt + tI dBt
It
N
dPt,T
N
Pt,T
R
dPt,T
R
Pt,T
NQ
= rtN dt N (t, T ) dBt
= [rtR RI tI R (t, T )] dt R (t, T ) dBt RQ
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where
R,N (t, T ) =
T
t
R,N (t, u) du
The model, by assuming lognormal bond prices (ie, normally distributed rates), has the drawback of allowing instantaneous and forward rates to go negative from time to time, but, on the plus side, the
lognormal assumption provides analytical solutions for both bond
prices and inflation caps and floors. For example, the price at time
t of the zero-coupon inflation cap, struck at K and with maturity T,
can be written as an expectation under the risk neutral measure
Q
where
IT = It exp
T
t
T
Ct = E t
max(IT K, 0) exp
(rSN rSR ) ds
1
2
T
t
rsN ds
sI2 ds +
T
t
sI dBIQ
s
thus leading to a BlackScholes-type closed-form solution, by virtue

of the lognormality assumption.
FROM THEORY TO PRACTICE: INFLATION STRATEGIES IN
ACTION
New Skys investment strategies focus on inflation-linked products
(both cash and derivatives) in developed and emerging markets,
with other inflation-sensitive assets employed opportunistically.
The objective is to build a balanced portfolio of directional and
non-directional (arbitrage) inflation strategies, with attractive riskadjusted returns.
Risk management, comprising both quantitative and qualitative
aspects, is a very active part of our investment process and integral to our culture, as our foremost aim is to preserve and protect
capital. Indeed, our active approach to risk management, which has
resulted in quick responses to unexpected market conditions (such
as in the aftermath of the 2011 tsunami in Japan, clearly not a foreseeable event), has added considerable value to our portfolio, in terms
of both higher returns and lower risk. At its root, we believe that
risk management is about recognising the possibility that we too, as
all others, might occasionally be wrong, and asking what happens
then. Taking risk intelligently should minimise the chance of mistakes, while effective risk management should mitigate their effect
if (when) they do occur.
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In addition, besides identifying individual opportunities, the

portfolio-construction process takes into account their returnrisk
contribution to the portfolio (diversification, carry), as well as other
practical considerations (for example, convexity, ease of unwinding
under stressed conditions and market flows). Target stop-loss and
profit-taking exit points are also part of our disciplined process, and
are quite effective at limiting downside and creating a positively
convex distribution of portfolio returns.
As discussed earlier, we believe that the ideal investment approach to the inflation sector combines a fundamental view of what
is embedded in prices with an appreciation of the technical factors
affecting the market, the two often being correlated. Using such
an approach, it is possible to identify both directional and nondirectional inflation strategies and build portfolios with attractive
risk-adjusted expected returns and positive convexity, as well as
low, or even negative, correlation to other traditional asset classes. A
couple of real life examples of these strategies will be discussed next.
Example: directional trade
In this section, we shall review an example of a directional strategy.
A corollary of the discussion about the inflation risk premium in the
previous section is that, when it comes to trading BEI, unconditional
distributions have lost some of their significance, while the ability to
discern between different regimes, as well as understanding the role
that monetary policy and global markets might have in triggering
a transition from one regime to another, has become of paramount
importance.
One example of this is a short BEI trade we entered into on
August 1, 2011. Over the course of July, several economic indicators
showed substantial deterioration, with negative momentum intensifying over the last week of the month. Durable goods orders came
out at a negative 2.1% (on July 27; the number refers to the month of
June), while first quarter GDP was revised substantially lower to an
annualised rate of 0.4% (from 1.9%). At the same time, consumer sentiment plunged to its lowest reading in more than two years (on July
29)7 , and equities strongly sold off. This string of negative domestic
economic data came in the mist of political gridlock in the discussion
of the increase in the US debt ceiling, the threat of an imminent US
credit downgrade and mounting concerns in Europe (and Greece in
particular).
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Figure 19.16 Short 10-year BEI trade

3.0
2.9
2.8
2.7
2.71
2.6
2.5
2.4
2.3
2.2
2.1
2.29
Dec 2
Dec 16
Dec 30
Jan 13
Jan 27
Feb 10
Feb 24
Mar 10
Mar 24
Apr 7
Apr 21
May 5
Ma7 19
Jun 2
Jun 16
Jun 30
Jul 14
Jul 28
Aug 11
Aug 25
Sep 8
Sep 22
Oct 6
Oct 20
Nov 3
Nov 17
2.0
During the same period, the 10-year BEI rate held pretty steady,
and our estimate of the inflation risk premium stood solidly in positive territory, actually above the average of the conditional probability distribution. This and the overall macroeconomic picture suggested that a short BEI position had substantial upside in the case of
a regime shift (which we judged likely), and much less of a downside in case no such switch would occur. In reality, in the course of
the next 10 weeks, not only were BEI rates re-priced substantially
lower, but the inflation risk premium did in fact turn negative (Figure 19.11), as the market transitioned to pricing downside inflation
risk. The announcement of Operation Twist on September 21 also
contributed to a further step down in BEI rates, as nominal treasuries
rallied considerably after the news.
As it turns out, we entered the short BEI position on August 1 at
2.71%, and exited on October 6 at 2.29% (the actual trading pattern
was not linear, as technical effects also played a role).
Example: arbitrage trade
As explained earlier, swap BEI rates are typically higher than cash
BEI, mostly due to the difference in repo costs and ASW spreads
between nominal Treasuries and inflation-linked bonds.
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Figure 19.17 EU 10-year swap versus cash BEI spread

0.7
0.6
0.5
0.4
0.3
0.2
0.1
Apr 2012
Feb 2012
Oct 2011
Dec 2011
Aug 2011
Apr 2011
Jun 2011
Feb 2011
Oct 2010
Dec 2010
Aug 2010
Apr 2010
Jun 2010
Feb 2010
Dec 2009
Oct 2009
Jun 2009
0.1
Aug 2009
However, early in 2011, we saw the positive spread between the

euro 10-year swap and cash BEI compress close to zero (and even
negative) for a short period of time. Reasons for this were technical
in nature, as some demand for inflation swaps shifted to the 30-year
maturity bucket (given the unusually flat BEI curve), while buyers
of inflation bonds shifted capital to EU linkers once their real yields
broke above 1%. Clearly this provided an attractive opportunity,
and a classic mean reversion trade, as the swapcash BEI spread
was close to a historical minimum, with significant upside volatility.
At the same time, higher oil prices at the onset of the Arab Spring,
and a substantial supply of inflation bonds in the pipeline (positive
for inflation expectations but not for linkers), provided, in our mind,
the likely catalysts for the reversion to equilibrium to quickly take
effect. There were also qualitative reasons why we liked this trade,
specifically the fact that it provided no directional macro exposure,
and had insurance qualities in a flight to liquidity/risk aversion
scenario. As it turns out, we entered the position (long EU 10-year
inflation swap, long 10-year nominal Bund, short 10-year German
Bundei) at a spread of 0.08% on March 9, 2011, let mean reversion
work its way to equilibrium and closed the trade on May 26, 2011,
at a spread of 0.31% (Figure 19.17).
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CONCLUSIONS
The inflation market provides a risk-transfer mechanism among
investors and hedgers. In this chapter, we explain how this market works, the different agents involved and what motivates them,
as well as the role of market makers in providing liquidity.
Inflation is not only an important macroeconomic factor but also
a risk that should be actively managed. Indeed, BEI rates displayed
equity-like volatility during the 20089 global crisis and have continued to do. This coincided with a substantial reduction in risk capacity on behalf of market makers, thus creating pricing distortions and
relative value opportunities.
In the first part of the chapter, we introduced some of the tools
essential to the analysis of the inflation market, including top-down
macroeconomic models and bottom-up pricing/market models. We
also described our investment philosophy and objectives, as well
as our holistic approach to the sector, which takes into account both
fundamental and technical considerations. Finally, we presented two
real-life examples of inflation strategies and the thought process/
analysis behind their evaluation.
APPENDIX: OIL PRICES SHOCK SCENARIO
This scenario might be relevant in a situation of renewed geopolitical
tension (we used this during the Arab Spring in 2011). A spike in oil
prices, if sustained, will translate in an increase in global headline
inflation. We shall focus on the impact in the US. In building this
scenario, we consider the direct effect on headline inflation (energy
being about 9% of CPI, although other items in the basket will also
be affected) and also on consumption (higher oil prices as an indirect
tax on consumers). We also assume a negative impact on real growth
and GDP.
We use a short-term model of inflation (Phillips curve and bottomup CPI-component analysis; see Figure 19.18), and output gap, after
which we let structural mean-reverting processes take hold. The path
of the short-term nominal rate is given by the Taylor rule (other
assumptions can be made). The evolution of inflation (swap) BEIs is
given by expectation plus a risk premium. Real rates are given by the
Fisher equation plus risk premium/covariance effect. As for monetary response, we expect the Feds to tighten in response, although
the rise in rates will be limited by the still negative output gap (see
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Figure 19.18
Spike in oil
prices and
CPI; growth
slows down
Feds raise
rates; output
gap remains
negative
Inflation BEs increase;
inflation linkers rally;
nominal bonds sell-off;
pressure on currency
and equity
the Taylor rule). If their response is inadequate (as it happened in

the 1970s), long-term inflation expectations will increase, affecting
both the level of and the speed to equilibrium, as well as market risk
premiums.
APPENDIX: THE INFLATION/DEFLATION DEBATE IN THE US
In the US, we believe that inflation surprises are possible, and are
most likely to occur on the upside. Clearly, debt levels are high
(about US$15.7 trillion as of May 2012, of which about 70% is held
by the public, slightly higher than nominal GDP as of 2012 Q1), and
projected to increase considerably in the future. Furthermore, the
federal deficit is in the high single digits and balancing the budget
faces strong headwinds, because of insufficient growth of tax revenues, unfavourable demographics (the baby-boomer generation
retiring) and ballooning pension and medical cost liabilities (Social
Security, Medicaid, Medicare whose NPV is estimated to be about
US$4550 trillion). The overall fiscal situation is not only complex,
but also politically sensitive.
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In addition, the Feds and Treasurys balance sheets have grown

considerably since the crisis because of aggressive quantitative easing programmes aimed at avoiding the dangers of a deflation spiral.
The effect on the money supply has been modest thus far, but all
of this can quickly change as the money multiplier/velocity revert
to more typical levels. Pressure from external shocks, such as commodity/food prices (increased political unrest, bad weather in several parts of the world affecting crops) slightly subsided after 2011,
but clearly affected headline figures, and to a lesser degree core
measures, in the recent past.
At New Sky, we do not believe high inflation is inescapable. In
fact, effective reform in the area of non-discretional spending and
defence would mitigate the risk on the fiscal side. In addition, the
Feds, as the first line of defence, do have effective tools of monetary
policy and have used them judiciously, albeit not perfectly, in the past
(at least in the post-Volcker era). The Feds and the Treasury can also
manage a gradual reduction in their balance sheets without undue
disruption to markets, although the process is intrinsically delicate
and sensitivities are high. As for external shocks, these might be,
at least in part, self-correcting (although a case might be made for
secularly increasing mean-reverting levels).
However, upside risks to inflation are clearly present, as postcrisis budget battles have focused on a few billions of US dollars
worth of discretional spending, thus addressing neither the core nor
the magnitude of the fiscal problem. It is not clear how the politics
of the process will play out. In addition, even with reduction in Feds
and Treasurys QE programmes being underway, given their sheer
size, exit strategies are delicate, implying a high sensitivity to errors
in policy.
Despite the debt/fiscal situation, and pressure from energy and
food prices clearly evident in headline CPI and PPI over the course of
2011, the Feds have traditionally focused on core inflation measures.
This is based on the view that external shocks are temporary, and
their effect on inflation should also be temporary, provided there is
long-term anchoring of inflation expectations (the argument is that,
once the shock subsides, headline inflation will mean revert to the
long-term target, unless the market loses confidence in the ability/
willingness of the Feds to take any appropriate monetary action).
Indeed, in the post-Volcker era, empirical evidence points to the
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fact that the focus on core inflation measures has worked well, in
the sense that core inflation has remained within range, irrespective
of commodity shocks, and with very limited monetary response to
those shocks (this is not true in the pre-Volcker era; see Evans and
Fisher (2011)).
In our opinion, however, the argument is dangerously backwardslooking, especially when we consider the difference in secular macro
trends at play, in particular the demographics of higher consumptions in emerging markets and the possibility that the latter might
turn from a deflationary to an inflationary global force. These secular changes may or may not play out (as usual, other effects such
as moderation of growth in emerging markets and/or technology
advances might counteract these forces). In any case, these effects
are never captured within the model, and if they materialise, they
will come as a surprise to many forecasters.
1
Refer to Chapters 7 and 20 for a brief history of inflation indexation in developed and emerging
countries respectively.
Keynes advocated the use of inflation-linked bonds in his testimony before the Colwyn
Committee on National Debt and Taxation in 1924.
Clearly, inflation-linked bonds also pay a semiannual coupon. Coupon cashflows can be
replicated by a portfolio of zero-coupon swaps and treasury strips, for each coupon date
(Fleckenstein et al 2010).
The five-year BEI breached the 2% level.
The five-year US TIPS Par ASW spread widened to 200 basis points over Libor. This was a
liquidity effect that did not affect nominal treasury ASW.
Examples of sudden shifts in inflation markets include those triggered by new regulations,
such as the indexation of tax-exempt saving accounts in France in 2003 (which created strong
demand for inflation-hedging products almost overnight) and the indexation of UK pension
annuities following the Pension Plan Act of 1995. Accounting regulations, especially those
pertaining to retirement benefits and their valuation (such as FRS17 in the UK), can also have
a profound effect on inflation players and markets.
See http://www.newskycapital.com/images/JUL11.pdf.
REFERENCES
Adrian, T., and H. Wu, 2010, The Term Structure of Inflation Expectations, Staff
Report 362, Federal Reserve Bank of New York.
Ang, A., G. Bekaert and M. Wei, 2008, The Term Structure of Real Rates and Expected
Inflation, The Journal of Finance 63(2), pp. 797849.
Chernov, M., and P. Mueller, Forthcoming, The Term Structure of Inflation Expectations,
Journal of Financial Economics.
Dickey, D., and W. Fuller, 1981, Likelihood Ratio Statistics for Autoregressive Time Series
with a Unit Root, Econometrica 49, pp. 105772.
476
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perrucci 2012/7/11 17:12 page 477 #499
Engle, R. F., and C. W. J. Granger, 1987, Co-Integration End Error Correction: Representation, Estimation, and Testing, Econometrica 55, pp. 25176.
Evans, C., and J. D. M. Fisher, 2011, What Are the Implications of Rising Commodity
Prices for Inflation and Monetary Policy?, Chicago Fed Letter, May, p. 286.
Fleckenstein, M., F. A. Longstaff and H. Lustig, 2010, Why Does the Treasury Issue TIPS?
The TIPS-Treasury Bond Puzzle, Working Paper, UCLA.
Garcia, J., and T. Werner, 2010, Inflation Risks and Inflation Risk Premia, Working Paper
Series, No. 1162, European Central Bank.
Jarrow, R., and Y. Yildirim, 2003, Pricing Treasury Inflation Protected Securities and
Related Derivatives using an HJM model, Journal of Financial and Quantitative Analysis
38(2), pp. 337358.
Johansen, S., 1991, Estimation and Hypothesis Testing of Cointegration Vectors in
Gaussian Vector Autoregressive Models, Econometrica 59(6), pp. 155180.
Phillips, P. C. B., and P. Perron, 1988, Testing for Unit Roots in Time Series Regression,
Biometrika 75, pp. 33546.
Perrucci, S., 2009, Inflation: The Real Opportunity, URL: https://www.newskycapital
.com/.
Vasicek, O., 1977, An Equilibrium Characterization of the Term Structure, Journal of
Wilson Committee, 1980, Report of the Committee to Review the Functioning of Financial
Institutions (Chairman Sir Harold Wilson), Command Paper 7937 (London: HMSO).
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20
Inflation Indexation and Products in

Emerging Markets
Brice Bnaben, Stefania A. Perrucci

New Sky Capital
Emerging countries have been pioneers in the inflation market.

Brazil, Israel and Iceland issued their first inflation-linked bond in
1964; Chile and Colombia issued their first in 1967. For such pioneers, issuing inflation-linked debt provided one of the few viable
long-term funding options to support on-going infrastructure and
agriculture projects in the backdrop of the persistent high inflation
environment of the 1960s, 1970s and 1980s (Figure 20.1). This contrasts with what occurred in developed countries. At the time of
writing, the latter are the largest issuers of inflation-linked debt, but
their inflation-linked programmes started much later,1 and, with the
exception of the UK, not as a way to counteract high inflation but
in order to meet investors demand for stable yields and portfolio
diversification.
Although emerging countries inflation-linked debt accounts for
only 20% of the total (Figure 20.2), it grew at a rapid pace from the
early 2000s onwards, especially in Latin American countries (which
together comprise three-quarters of emerging markets inflationlinked issuance), particularly Brazil, where such growth was spurred
by brisk economic activity combined with relatively high inflation.
At the same time, the evolution of domestic pension funds and insurance companies has also created additional structural demand for
real return assets. In addition, while emerging markets inflationlinked debt has traditionally been absorbed by local demand, this has
gradually changed, and growing interest on behalf of international
investors has indeed been one of the reasons behind the growth in
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Figure 20.1 Year-on-year inflation rate in emerging countries

140
120
100
80
%
60
40
1969
1970
1972
1974
1976
1978
1980
1981
1983
1985
1987
1989
1991
1992
1994
1996
1998
2000
2002
2003
2005
2007
2009
2011
20
Sources: International Monetary Fund (2004), New Sky Capital.
Figure 20.2 Size of inflation-linked debt: developed versus emerging

markets
Australia
1%
Canada
3%
Japan
2%
Germany
2%
Emerging
markets
20%
US
35%
Italy 5%
France
9%
UK
22%
Sources: Bloomberg, New Sky Capital; data as of March 2012.
issuance, a phenomenon we have observed across several emerging

countries not just in Latin America, but in Asia as well.
In this chapter, we analyse the key developments in inflationlinked markets in emerging countries. In the first part, we focus
on the historical development of the inflation indexation mechanism, with a focus on Latin American countries, which were the
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INFLATION INDEXATION AND PRODUCTS IN EMERGING MARKETS
early issuers of inflation-linked debt and, together, account for most

(about three-quarters) of emerging markets inflation-linked debt
outstanding. Although these countries still dominate the emerging
markets inflation-linked debt sector, we also mention the positive
prospects for the growth we see elsewhere, particularly in Asia.
The second part of the chapter discusses the detailed characteristics of several of the inflation-linked instruments issued in emerging
countries, covering not only the common features but also the specificities of each market. Given that, from Latin America to Africa and
Asia, about 20 emerging countries have issued inflation-linked debt
(and more are adding to the count, eg, Hong Kong, Thailand and
Russia, or considering resuming issuance again, eg, India), a comprehensive treatment of every traded instrument would be tedious
and beyond the scope of this chapter. Therefore, we shall focus on
the inflation-linked products that offer the most liquid opportunities
in the space, as these are the instruments on which foreign investors
demand is likely to concentrate.
THE EVOLUTION OF INFLATION INDEXATION IN EMERGING
MARKETS
In this section, we focus on the history and development of the
modern-era inflation indexation mechanism, with a focus on Latin
American countries, which have been the pioneers in issuing inflation-linked debt and, together, still account for the vast majority of emerging markets inflation-linked debt outstanding. Next
we discuss the evolution of the inflation indexation mechanism in
other emerging markets, specifically in Asia, where inflation-linked
issuance is still small and, in many aspects, in its infancy, and yet we
see potential for significant growth in the years to come.
When it comes to inflation indexation, history, for example, in
Latin America, has exposed some weaknesses and practical limitations of this risk transfer mechanism, especially when it comes
to consumer products. However, the benefits of indexed financial
products for pension funds and insurance companies are also well
recognised, and these have contributed substantially to the demand
for these products across the globe. At the same time, the overall
regulatory framework regarding inflation indexation has evolved
quickly, especially in the area of risk and assetliability management, with inflation-linked instruments becoming a key hedging
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tool: a development that contributes further to structural demand in

the sector.
Another reason that, in our opinion, the developments of inflation-linked instruments will be sustained is the intrinsic uncertainty
around inflation, even in the instances where monetary policy has
been successful in anchoring long-term expectations. Indeed, noncore components of inflation, ie, energy and food products, which
are the hardest to predict, have shown increased volatility in the
first decade of the 21st century, thus contributing to higher volatility in headline inflation, through first- and second-order effects. The
underlying causes are complex and multiple (weather, global warming, geopolitical tensions, changes in food consumption in countries
such as China, population growth, globalisation of economies) and
more likely than not to continue. In addition, these effects are amplified by the fact that, as seen in Chapter 3, food products in consumption baskets in emerging markets have, on average, more than twice
the weight of those in developed countries. This provides an additional challenge to monetary policy in emerging markets, and has
become a topical issue of discussion in both financial and academic
circles.
Because of all these factors, a plausible outcome is the continuation of the trend we saw at the end of the 2000s, with developed
and emerging countries promoting liquidity and issuance in both
their nominal and real debt markets. In other words, Latin American countries, historically the pioneers of inflation indexation, have,
over time, thanks to more stable economies and prices levels, started
to develop their nominal debt markets as well. In contrast, the US
and several European and Asian countries, where high inflation has
been less of an issue in the past and which have a large nominal debt
market, have started to develop inflation indexation as an alternative funding mechanism, in the wake of increasing investor demand,
in particular from insurance companies and pension funds.
Latin America
Latin American countries have some of the oldest and most advanced inflation-linked financial markets, which include several
active agents (such as the domestic government, local banks, pensions funds and insurance companies) and several inflation instruments (such as inflation-linked sovereign bonds, and inflationlinked mortgage/consumer loans and securities).
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From the 1960s to the 1990s, most Latin American countries experienced high inflation, and even hyperinflation, often caused by
the running of large structural fiscal deficits, which were financed
by printing money. In turn, excessive money growth resulted in
higher prices, and higher inflation expectations; the latter are an
important factor, as the de-anchoring of inflation expectations
explains the persistence of very high inflation in Latin American
countries for the greatest part of this period. According to Bernanke
(2005), the root of the problem was in the implementation of so-called
structuralist theories of development, which involve the protection of domestic companies from international competition. Domestic governments played an important role in this, by implementing
measures to prevent foreign competitors from entering local markets, and by heavily subsidising entire sectors of the economy. However, this came at the cost of chronic budget deficits, expansion in
monetary aggregates and mounting inflationary pressure.
Indeed, inflation indexation policies arose within the context of
high and persistent inflation, with domestic governments having
little choice but to issue inflation-linked debt as a way to secure
long-term funding in local currency. For example, after its creation
in 1953, the State Bank of Chile issued bonds to finance an ambitious
programme of development in the countrys agriculture and infrastructure sectors. Due to investors concerns about inflation and the
Chilean currency, these bonds were initially indexed to the US dollar. Then, in 1967, the authorities introduced a new unit of account,
the Unidad de Fomento (UF), tied to the ndice de Precios al
Consumidor (IPC), the Chilean Consumer Price Index. Such an
indexed unit of account has been the subject of several academic
papers (see, for example, Shiller 1998) and finds its roots in the
monetarist theory of Irving Fisher (1911). In the case of Chile, inflation indexation was soon applied not just to government bonds,
but also to a host of other financial transactions, including bank
deposits, residential rents, mortgage loans, house and commercial
property prices, alimony and child support payments and taxes.
Several Latin American countries followed a similar path. Ecuador
created the Unidad de Valor Constante in 1993; Mexico established
the Unidad de Inversion in 1995; Colombia created the Unidad
de Poder Adquisitivo Constante in 1972 and Uruguay adopted the
Unidad Reajustable in 1968.
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From the 1990s onwards, faced with the negative impact of persistent high inflation, Latin American countries began to focus their
economic policies on the task of stabilising prices. Currency pegs
were introduced in several countries as a way to enforce fiscal discipline and anchor inflation expectations, a necessary condition for
long-term price stability. Mexico pegged its currency in 1987, as did
Argentina in 1991, while Brazil adopted a crawling band regime
in 1994. Although there were some early successes and inflation
rates decreased, currency-targeting policies could not be sustained
for a host of reasons. First, local governments in these emerging
countries lacked credibility in their fiscal and monetary policies. In
addition, currency pegs created barriers in the free movement of
capital across borders, thus affecting the stability of the domestic
economies. Furthermore, these pegged currencies were perceived
as over-valued and became the subject of intense market speculation. All of these factors forced governments to give up the currency
pegs (Mexico in 1994, Brazil in 1999 and Argentina in 2002) and
devaluate. Of course, this raised prices dramatically, but inflation
rates stayed below the peaks reached in previous decades. These
currency-devaluation episodes did not change the Latin American
countries focus on lowering and stabilising inflation. Following the
example of several developed (eg, New Zealand) and developing
economies (eg, Chile in 1990), most Latin American countries shifted
their monetary policy framework from exchange rate targeting to
inflation targeting. Peru did so in 1994, with Brazil, Mexico and
Colombia following in 1999, after which inflation rates did indeed
decrease and stabilise.
In reality, the successful reining in of inflation was not simply the
consequence of inflation targeting monetary policies, but the result
of a more complex combination of factors. As Ben Bernanke said
during a speech at the Stanford Institute:
I do not mean to claim, however, that Latin America conquered
inflation simply by choosing a particular framework for monetary
policy. Rather, my more fundamental point is that inflation has
declined in Latin America because new ideas and new political
realities have fostered the development of economic institutions
and policies that promote macroeconomic stability more generally. Recent changes in the policy environment have been especially
important in three areas: fiscal policy, banking regulation, and central bank independence. No monetary policy regime, including
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inflation targeting, will succeed in reducing inflation permanently

in the face of unsustainable fiscal policies large and growing
deficits.
(Bernanke 2005)
Interestingly enough, the stabilisation of inflation rates induced

some Latin American countries to raise concerns on, and reconsider,
their indexation policies. For example, one issue with the linkage of
wages to inflation is that, as explained by Shiller (1998), indexation
might result in higher inflation expectations. This is a consequence
of the natural reluctance of individuals to accept a nominal salary cut
during low-inflation periods, while, on the opposite side of the coin,
it is easier, in non-indexed economies, not to raise nominal wages
in line with the full increase in inflation. In this case, a nominal
increase in salary, which still results in a lower real income, is psychologically easier to accept (the so called money illusion effect).
A second issue is the spillover of inflation risk and indexation into
credit risk. As we have seen, in Latin American countries, inflation
indexation was applied to a host of financial transactions, including consumer loans and mortgages. When local currencies devaluated and inflation rose, the nominal size of that debt increased significantly, putting extreme pressure on households and consumers
and triggering credit defaults. Social and political pressure on local
governments to fix these problems also mounted. For example,
in Chile, farmers, whose loans were UF-indexed, forcefully lobbied
the government to freeze the index of account. Some governments
tried to correct the indexation by fine-tuning indexes to better reflect
wages, but this did not resolve the public outcry against indexation.
However, these abrupt developments did not eliminate the use
of inflation indexation in Latin American financial markets. Indeed,
although some debate is still going on, especially in regard to the
topic of indexation of consumer loans, the sovereign inflation-linked
bond market is alive and well, with governments taking advantage
of long-term funding opportunities, and demand from institutional
investors growing stronger by the day.
The Latin American experience is of great historical and practical
importance in that it not only jump-started modern-era inflationlinked markets, but also created a standard for indexation of both
inflation-linked bonds and derivatives. Furthermore, the introduction of units of account as the translation mechanism between
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18
16
14
12
10
%
8
6
4
2
0
Jan 1980
Mar 1981
May 1982
Jul 1983
Sep 1984
Nov1985
Jan 1987
Mar 1988
May 1989
Jul 1990
Sep 1991
Nov1992
Jan 1994
Mar 1995
May 1996
Jul 1997
Sep 1998
Nov1999
Jan 2001
Mar 2002
May 2003
Jul 2004
Sep 2005
Nov 2006
Jan 2008
Mar 2009
May 2010
Jul 2011
Figure 20.3 Year-on-year Inflation in Asia
Sources: International Monetary Fund (2004), New Sky Capital.
the nominal and indexed economies brought about the concept of

currency analogy, which has proved fruitful in the modelling of
inflation-linked products, further contributing to the understanding
and acceptance of such instruments by financial and non-financial
agents around the world.
Asia: a sleeping giant?
As shown in Figure 20.3, Asia experienced high inflation rates over
most of the 20th century, with a peak in 1998 during the Asian Crisis.
In fact, after the economic miracle of the 1980s and 1990s, when
Asian economies experienced high growth and large foreign capital
inflows, the crisis started in 1997, triggered by a massive speculation
against the pegging of the Thai baht to the US dollar. The crisis also
quickly spread to other Asian countries, on the wings of a massive
withdrawal of foreign capital, which caused a credit crunch. There
were several economic factors (Kaufman et al 1999) that triggered
these events, but a key one was the sharp volatility and devaluation of several Asian currencies, and the consequent rise in inflation.
Between June 1997 and July 1998, the currency Thai baht/US dollar rate depreciated by 70% and the South Korean won/US dollar
rate depreciated by 54%, while the Indonesian rupiah/US dollar rate
rose from 2,450 to 14,750!
More recently, inflation in Asia rose again to reach about 8% in
2008 and 7% in 2011, mostly as a consequence of higher commodity
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prices and the dependence of these countries on oil and food imports.
However, Asian economies are also evolving, with domestic demand
growing considerably and playing a stronger role as a determinant
of inflation. In fact, according to Osorio and Unsal (2011):
The relative roles of key inflation drivers appear to be changing
over time. The role of supply shocks in driving inflation appears
to have fallen slightly in recent years, while the role of output
gaps has increased. The impact of monetary shocks on inflation in
Asia has diminished, particularly in economies that have relatively
clear monetary objectives and flexible exchange rate regimes (such
as Indonesia, Korea, the Philippines, and Thailand).
Osorio and Unsal also mention that demand-driven inflation spillover effects from China to the rest of Asia are significant, and arise
from both higher imported goods and commodity prices. These
forces are likely to continue, thus contributing to both inflation and
its volatility in the foreseeable future.
However, despite the historically high and volatile inflation experienced in many Asian countries, the inflation-linked market is still
in its infancy, with the size of the outstanding inflation-linked debt
accounting for only a very small percentage of the overall total (Figure 20.4). South Korea and Thailand have recently issued inflationlinked bonds (Table 20.1), but again the size of issuance is underwhelming. This might be the consequence of the relatively small
size of the fixed income market in these countries, with local governments prioritising the development of the nominal rate market.
Another possible explanation is that pension fund schemes and the
insurance sectors are still at a fairly embryonic stage in many of these
countries; thus, the demand side has still to fully develop.
There are signs that Asian inflation-linked markets have the
potential to flourish, and room to expand, in the future. First, the
evolution and growth of pension schemes and the insurance sector
might take time but they are unavoidable, and they will create solid
structural demand for inflation-linked products. Indeed, when, in
2011, Thailand issued its first inflation-linked bond, private and public pension funds were the main investor targets. Secondly, although
practical obstacles to foreign investors entering the space (such as
withholding the tax that applies to South Korean inflation-linked
bonds) are still present, a lively debate has ensued in official circles as to how to eliminate such impediments and thus broaden the
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First issuance
Inflation index
Index ticker (Bloomberg)
Market value (US$ bn)
Israel
Brazil
1964
1964
1967
1967
1972
1989
1992
1997
2000
2007
2011
ISCPINM
BZPIIPCA
IGPIBREIGPM
COCPI
CLCPI
ARCPI
MXCPI
POCPILB
TUCPI
SACPI
KOCPI
THCPI
41
Colombia
Chile
Argentina
Mexico
Poland
Turkey
South Africa
South Korea
Thailand
Israel CPI 2010 = 100

Brazil CPI IPCA
FGV Brazil General Prices
Colombia Consumer Prices Index
Chilean Consumer Price Index
Argentina CPI
Mexico CPI
Poland CPI Inflation Linked Bond
Turkey CPI
South Africa CPI 2008 = 100
South Korea CPI 2010 = 100
Thailand CPI All Items 2007 = 10
Total
Sources: Deacon et al (2004), Bloomberg, Barclays Capital, New Sky Capital.
281
2
14
13
53
7
48
31
6
2
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Country
488
Table 20.1 Main issuers of inflation-linked bonds in emerging markets
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investor base. Finally, the appeal of inflation-linked bonds for debt

management purposes and as an important instrument in support
of an expanding pension system has been increasingly recognised.
One of the conclusions of the IMF working paper by Poirson et al
(2007) was that
debt management agencies and regulators can support the provision of new instruments for retirement savings by ensuring liquid
government bonds (that serve an important benchmark function
for the private sector) and issuing price indexed bonds (to support
the issue of price-indexed annuities).
Indeed, large Asian countries such as India have the potential to

become important issuers of inflation-linked bonds. India issued
its first five-year maturity Capital Index Bond in December 1997,
for which only the principal repayments at maturity were linked to
inflation. In 2010, the Reserve Bank of India launched a consultation
paper to reissue inflation-linked bonds. In a technical paper,2 a new
structure for the inflation-linked bonds was defined, where both
interest and principal payments were to be linked to inflation (similarly to US Treasury Protected Securities (TIPS)), through the Whole
Price Index, with a four-month lag. As of spring 2012, India had in
fact authorised the issuance of inflation-linked bonds. Such a decision reflects not only the desire to address the issue of high inflation
rates, but also a strong motivation in providing financial instruments
that might help to build a solid domestic pension system.
All these signs indicate that Asia may not remain a sleeping
giant forever, and could quickly become an important player in the
inflation-linked market.
EMERGING MARKETS INFLATION-LINKED PRODUCTS
After analysing the evolution of inflation indexation in emerging
markets, in this section we focus on inflation-linked products, their
structure and their liquidity, as well as some of the inflation strategies
employed by specialised asset managers and hedge funds. About
20 emerging market countries have issued inflation-linked bonds,
but we shall not cover all of them. Rather, we shall focus on the
countries and instruments that offer the most liquid opportunities
and are fairly accessible to foreign investors.
Figure 20.4 shows a breakdown of outstanding inflation-linked
debt by country, and additional information is provided in Table 20.1
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Figure 20.4 Emerging market inflation-linked bonds outstanding by

country
Israel
8%
Argentina
3%
South Africa
6%
Poland
1%
Turkey
10%
Thailand
1%
Brazil
56%
Mexico
11%
South Korea
1%
Chile
3%
Colombia
0%
(sorted by first issuance date). Brazil has the largest stock of inflationlinked bonds (US$281 billion equivalent), followed by Mexico,
Turkey and Israel.
As seen in Table 20.1, Israel and Latin American countries pioneered inflation indexation and, as a result, these markets offer a
wider range of inflation-linked products, ie, bonds and derivatives
as well as several underlying indexes, and an array of domestic and
foreign investors, from pension funds to insurance companies and
asset managers, active in the space. Other countries are newer to
inflation indexation, and their markets are somewhat less sophisticated, with fewer products available, the latter typically being
sovereign inflation-linked bonds with a structure similar to US TIPS.
However, even these countries (one example being South Africa)
have been developing quickly in line with a parallel evolution of
their pension fund sectors sponsoring demand for these products.
At the same time, foreign demand has also risen considerably.
International institutional investors are actively allocating a portion of their assets to global inflation products, including emerging markets. Other emerging market investors are also considering
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inflation-linked strategies. Finally, pension funds, especially those

of multinational companies with employees in emerging countries,
are also strategically investing in the sector. Although investing in
emerging markets still has many obstacles (such as currency deliverability, local and foreign tax treatment), demand for inflation-linked
products has also been supported by the creation of global inflation
indexes and new vehicles, such as exchange-traded funds (ETFs),
that offer exposure to such indexes.3
Brazil
Brazil has one of the oldest and largest inflation markets, offering
a variety of instruments including inflation-linked government and
corporate bonds and inflation-linked derivatives such as swaps.
Sovereign bonds are clearly the most liquid inflation products,
and they have been central to the Brazilian National Treasurys funding strategy. This strategy has hinged on promoting inflation-linked
and fixed rate issuance while reducing the share of floating rate
bonds, with the objective of lengthening the average maturity of the
debt,4 thus reducing the need for short-term refinancing. Indeed, the
National Treasury also establishes targets for different types of debt
outstanding, based on its analysis of funding costs and risks (Tesouro
Nacional 2011). From Table 20.2, we can see that in 2011, the National
Treasury of Brazil estimated a long-term target of about one-third
of inflation-linked debt to be optimal (that is a range between 30%
and 35%). Interestingly enough, this figure is in line with similar
analysis conducted, and conclusions adopted, by several other large
sovereign inflation-linked issuers worldwide.
Inflation-linked bonds play an important role in the management of sovereign debt, with their virtues eloquently highlighted
by Tesouro Nacional (2011):
Although a significant share of the debt is indexed to inflation, the
risks associated to that indexing factor are attenuated by a series
of other factors. In the first place, changes in price indices provoke
alterations in nominal federal public debt stock, but not in the
real value of the outstanding debt measured as a percentage of the
GDP. Secondly, an important share of federal government revenues
shows a high correlation with inflation, thus providing a hedge to
the share of the debt indexed to inflation. Thirdly, in an inflation
target system, one expects that the index used as a reference be
maintained under control over time, with volatility well below
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Table 20.2 Brazil: federal public debt breakdown in 2011 and target
ranges
Target range

Type
2011
weights (%)
Lower
limit (%)
Upper
limit (%)
36.6
26.6
31.6
5.2
40
30
10
5
50
35
20
10
Fixed rate
inflation linked
Floating rate
Foreign currency
Sources: National Treasury of Brazil, New Sky Capital.
Figure 20.5 Asset allocation of different financial and economic agents

18%
25%
15%
17%
41%
53%
24%
54%
20%
70%
24%
21%
63%
27%
52%
19%
2%
63%
4%
25%
11%
Financial Funds Pensions NonGovern- Insurers
institutions
residents ment
Other
Floating
Fixed-rate
33%
2%
Other
Inflation-linked
Sources: National Treasury of Brazil, New Sky Capital.
that observed in other financial variables such as interest rates and

exchange rate.
Another important role has to do with domestic institutional

investors, especially pension funds and insurance companies, who
have long-term liabilities often linked to inflation. For these two
types of investor, inflation-linked bonds provide a natural hedge,
and this is indeed reflected in their asset allocation (Figure 20.5).
In contrast to the vibrant domestic market, access to Brazilian
inflation-linked bonds provides challenges to offshore investors,
given that the Brazilian real is not fully convertible into the major
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Table 20.3 Brazilian price indexes

IPC-A
IGP-M
Price index
Average cost of living Market General Price

in 11 major Brazilian Index
cities for families with
income from 1x up to
40x minimum wage
Publisher
Instituto Brasiliero de Fundacao Getulio

Geografiae
Varga (independent
Estatistica
foundation)
(sponsored by
Federal Government)
Period covered
First to last day of the 21st of the previous

month
month to the 20th of
the month of
reference
Publication
The inflation for a

given month is
reported on the 15th
day of the following
month
The index for a given

month can be
published at or
before month end
Bloomberg ticker BZCLVLUE
IBREIGPM
Breakdown
60% wholesale, 30%

consumer and 10%
of construction prices
Aug 1994 = 100
70% markets, 30%

administered prices
Base
Dec 1993 = 100
Seasonality
Non-seasonally
adjusted
currencies and foreign investment in fixed-income products is contingent to the payment of an upfront withholding tax (typically 1.5%
of notional). These factors are at the root of the developments of the
inflation swap market in Brazil, as we shall discuss later on.
As for the mechanics of sovereign Brazilian inflation-linked
bonds, several indexes and indexation methods have been used
since the start of the market in the 1960s. For example, in the early
1970s, indexation was based on a combination of both realised and
projected (by the government) inflation rates (Deacon et al 2004),
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Figure 20.6 Brazilian annual inflation rates (IPC-A) and policy targets
YoY inflation
Inflation target
Jan 1999
Aug 1999
Mar 2000
Dec 2000
May 2001
Dec 2001
Jul 2002
Feb 2003
Sep 2003
Apr 2004
Nov 2004
Jun 2005
Jan 2006
Aug 2006
Mar 2007
Dec 2008
Jul 2009
Feb 2010
Sep 2010
Apr 2011
Nov 2011
20
18
16
14
12
% 10
8
6
4
2
0
Source: Bloomberg.
in an effort to minimise feedback effects from past to future inflation. Later, a fixed equilibrium rate replaced future projections. In
the mid 1970s, supply shocks corrections were introduced, which
effectively reduced government funding costs, but to the detriment
of investors.
As of spring 2012, two types of sovereign inflation-linked bonds
remain outstanding, the Notas de Tesouro Nacional-C (NTN-C) and
the NTN-B. The NTN-Cs, linked to the IGP-M index (Table 20.3),
were first issued in 1990 during the implementation of the Collor Plan I, aimed at stabilising the economy and inflation. Their
issuance was suspended in 1994 with the introduction of the Piano
Real, but resumed in 1999. The NTN-Bs, linked to the IPC-A index,
were introduced in 2002. At the time of writing they constitute most
of the inflation-linked debt outstanding (Table 20.4), as a result of
the Brazilian government focusing issuance on a single price index,
that is the IPC-A, in order to improve market depth and liquidity.
Indeed, the NTN-Cs share of inflation debt decreased from 75% in
2004 to 13% in 2011.
The choice of the IPC-A index is natural when we consider that
this is the same index adopted by the Brazilian Central Bank (BCB) in
conducting its inflation-targeting policy. This policy framework was
introduced in July 1999, six months after the BCB adopted a floating exchange rate system. Since then, the government has defined
inflation targets for the coming years (Figure 20.6) and given to BCB
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Table 20.4 Brazilian government inflation-linked debt

NTN-B
NTN-C
First issuance
2002
Outstanding (R, billions) 209
1990
25
Inflation index
Bloomberg index ticker
IPC-A
BZCLVLUE
IGPM
IBREIGPM
Auction
Up to two auctions
per month and swap
auction (buy short
term and sell longer
term)
Irregular
Coupon
Semiannual at 6%
Semiannual at 6% or
12%
Floor
Quotation
No
Nominal dirty
No
Nominal dirty
Date count fraction

Number of bonds
Maturity
Business/252
15
2012,. . . ,2050
Business/253
3
Bloomberg ticker
BNTNB
2012, 2017, 2032

BNTNC
the responsibility (and the operational independence) to conduct

monetary policy in pursue of those targets, with the goal of promoting economic growth in an environment of price stability and
sustainable employment rate.
The format of NTN-Bs and NTN-Cs is the standard one used for
most inflation-linked bonds where the notional amount is linked
to an inflation index.5 The coupon is calculated by multiplying a
fixed rate by the inflation-accruing bond notional amount and is paid
semi-annually. At maturity, the full inflated notional is paid down,
and for Brazilian bonds there is no deflation floor, unlike for US TIPS.
Another specificity of Brazilian inflation-linked bonds is the absence
of inflation lag in the bond index.6 This raises the issue of how to
convert nominal into real prices. In Brazil, the NTN-Bs and NTN-Cs
are quoted in dirty nominal prices at time t, for settlement at time t+1.
However, the index is not known at settlement. Therefore, to obtain
real prices and yields, the market convention is to use the index
value assumption, as published twice per month by the Andima,
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Settlement date
Quoted price (nominal dirty price for a par value of 1,000)
(1) Base Bond Index (at bond issuance)
Latest IPCA: (April 2012)
Number of business days in the accrual period (from May 15 to June 15)
Number of business days accrued (from May 15 to May 21)
IPCA assumption (published by Andima)
(2) Bond index at settlement date: 3467.46 (1 + 0.46%)4/22 =
(3) Bond index ratio: (2)/(1)
Real dirty price = 2,870/(3)
Semi-annual coupon (1+6%)0.5 1
Number of days since the last coupon date
Number of days between two coupon dates
(4) Real accrued coupon: 2.956 64/125 =
Nominal accrued coupon: (4) (3)
Real clean price
NTN-B 6%, August 15, 2040

May 21, 2012
2,870
1614.62
3467.46
22
4
0.46
3,470.35
2.14933
1335.3
2.956%
64
125
15.14
32.541
1,320.16
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Linker
496
Table 20.5 From nominal dirty price to clean price
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the Brazilian National Association of Financial Market Institutions.

When the actual index value is released, it replaces the assumption
by Andima. Table 20.5 provides an example of price calculation.
Inflation swaps are also traded in Brazil, in addition to cash bonds.
Demand from foreign investors has been key to the development of
these instruments, whose structure resembles total return swaps,
rather than the zero-coupon format which is the structure of choice
catered to pension funds demand in Europe and the US. In a Brazilian inflation swap, the inflation-linked leg mirrors the cashflows of
inflation-linked bonds, while the floating leg is linked to money market rates, specifically the CDI rate published by CETIP, the Brazilian
Over-the-Counter Securities and Derivatives Association. All cashflows are settled in US dollars, and the market convention is to
use the PTAX800 exchange rate, as quoted by the Banco Central do
Brasil. Note that, because Brazilian inflation swaps involve both the
inflation index and the exchange rate, their valuation is rather complex, akin to a quanto, where we need to consider the stochastic
evolution of both stochastic variables as well as their correlation.
Chile
As discussed previously, Chile has been a pioneer in inflation indexation, having introduced in the 1960s the Unidad de Fomento
(UF), still in use at the time of writing. The UF is a daily price index
published by the Chilean government, and based on the ndice de
Precios al Consumidor (IPC), the Chilean Consumer Price Index.
As shown in Figure 20.4, the size of Chilean sovereign inflationlinked debt is much smaller than the similar outstanding debt in
other emerging market countries, such as Brazil and Mexico. Indeed,
overall sovereign debt in Chile was on a downwards trend until
the 20089 global financial crisis (for example, as a percentage of
GDP). In addition, as the countrys economy has followed a path
of stabilisation and lower inflation, some emphasis has been shifted
to the development of a liquid nominal debt market in local currency. Despite these effects, the inflation-linked market in Chile
has preserved good liquidity and, notably, since the crisis its size
still accounts for about two-thirds of total sovereign inflation-linked
market in the country.
The two main inflation-linked bonds in Chile are the Bonos de la
Tesorera General de la Repblica en Unidad de Fomento (BTUs)
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Table 20.6 Chilean sovereign inflation-linked debt outstanding
Debt outstanding (UF million)
BTUs
BCUs
401
354
Sources: Bloomberg, Barclays, New Sky Capital.
and the Bonos del Banco Central de Chile (BCUs). The BTUs are
issued by the government, which uses the central bank as its agent.
In general, the government issuance follows a budget-stabiliser type
of strategy, which means an increase in net issuance when the economic activity is below its potential, and vice versa. As a result, the
issuance of BTUs decreased between 2000 and 2008, only to then
increase again afterwards. BTUs maturities range from 5 to 30 years.
The BCUs are issued by the central bank rather than the government. They play an important role in conducting monetary policy,
for example, in sterilised interventions, which aim at controlling the
foreign exchange rate.7 BCUs maturities range from 2 to 20 years.
Investors in BTUs and BCUs are typically domestic institutions, pension funds and insurance companies in particular. In general, taxation on interests and capital gains continues to be an obstacle for
most offshore investors (Barclays Capital 2012).
Similarly to sovereign bonds, the vast majority (92% of issues)
of corporate bonds are denominated in UF. In addition, derivatives instruments also trade with good liquidity. For short maturities
(within 18 months), forwards contracts on the UF index trade daily
via electronic platforms. In these contracts, one counterpart agrees
to pay the UF index in exchange for the variable short-term rate
Camara, which represents the average funding cost for domestic
financial institutions and is published daily by the Chilean Banking Association. For longer maturities (1Y, 5Y, 10Y and up to 30Y),
two types of real rate swaps are traded, with the real leg mirroring
the cashflows of inflation-linked bonds. One is the UF/Camara
swap, denominated in local currency. The other is the UF/Libor
swap, which settles in US dollars and has the quanto features we
previously hinted at when discussing Brazilian swaps.
Mexico
Mexico has the second largest stock (after Brazil) of inflation-linked
bonds in emerging markets countries. The first inflation-linked
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Table 20.7 List and outstanding size of UDIBonos
Coupon
Maturity
date
Issue
date
Outstanding
(Ps, billion)
3.25
5.5
3.5
4.5
5
3.5
4
2.5
4.5
4.5
4
Jun 2012
Dec 2012
Dec 2013
Dec 2014
Jun 2016
Dec 2017
Jun 2019
Dec 2020
Dec 2025
Nov 2035
Nov 2040
Jan 2009
Jan 2003
Jan 2004
Jan 2005
Jul 2006
Jan 2008
Jul 2009
Mar 2011
Jan 2006
Jan 2006
Mar 2010
7.2
9.0
10.2
15.1
10.8
13.3
10.2
11.8
8.6
24.3
20.3
Total
141.0
bonds were issued in 1996, two years after the Mexican pesos
crisis. Over time, with inflation stabilising and a nominal domestic debt market developing, the percentage of inflation-linked debt
has decreased from a peak of about 30% in the 1990s to about 20%
as of 2012. Given the importance of these instruments in meeting
demand from domestic institutions, and the governments focus on
supporting the evolution of a modern pension system, issuance of
sovereign inflation-linked bonds is here to stay.
In Mexico all inflation products are linked to the Unidad de
Inversion (UDI), which is an official index computed by the central
bank every two weeks. This index tracks the changes in the ndice
Nacional de Precios al Consumidor (INPC).8
Mexican sovereign inflation-linked bonds are called UDIBonos
(Table 20.7). Their structure is similar to the TIPS structure, where
a real coupon rate is applied to an UDI-inflated notional. The central bank, Banxico, acts as an agent of the Treasury and auctions
the bonds. To maintain a good level of market liquidity, the government runs a regular issuance schedule as well as auctions, where
long-dated bonds are exchanged for short-dated ones. Demand is
driven by domestic institutions, such as pension funds and insurance
companies, with long-term inflation-sensitive liabilities. Demand
from offshore investors, albeit on the rise at the time of writing,
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remains below 10% (Barclays Capital 2012) in spite of favourable

tax treatment.9
The inflation-linked swap market is well developed with both
onshore and offshore institutional players. As in most Latin American countries, there are two swap formats, one catering to domestic
investors and the other to foreign investors. In the first, the USI/TIIE
swap, a real UDI fixed rate is exchanged for the benchmark Mexican interbank deposit rate (TIIE). Principals are also exchanged at
the start and the end of the swap contract. The second structure,
the UDI/Libor swap, is aimed at offshore investors and combines
a real swap with a cross-currency swap. In this swap, the fixed leg
pays USI real rate in pesos, and receives a floating Libor rate on a US
notional. Principals in the two currencies are exchanged at the start
and end of the swap contract.
Israel
Israel is one of the oldest issuers of inflation-linked bonds. Indeed,
the evolution of its market shares many similarities with the economic realities faced by Latin American countries, ie, chronic inflation in the 20th century and the subsequent policy responses (Barnea
and Liviatan 2008).
The first issuance of indexed bonds by the Israeli government
occurred in 1964, a time marked by high inflation and substantial
government financing needs. In such an environment, the government could effectively fund itself only by issuing in hard currency
(US dollars) or indexing to inflation. Indeed, by the 1980s, a period
when inflation rates ranged between 100% and 450% per annum, the
vast majority of government debt was indexed. In 1985, the government started a reform programme aimed at stabilising the economy
and reducing inflation. The role of the government in the economy
was reduced, and so were the fiscal deficit and public debt. In addition, more independence was given to the central bank (Deacon et
al 2004).
Consequently, the share of indexed bonds started to decrease. In
1992, a new law clearly defined the objective of monetary policy
as to maintain price stability in order to help to create a business
environment that supports sustainable economic growth.10 Inflation targeting was adopted, with the short-term rate as the monetary
policy tool of choice, controlled by the Bank of Israel. The dramatic
effect of these policy reforms is clear from Figure 20.7.
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Figure 20.7 Reduction in annual inflation rates in Israel from 1995

14
12
10
8
6
4
2
0
2
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
In the wake of these developments, the government funding strategy has gradually shifted on establishing a liquid nominal bond market. The share of inflation-linked bonds as a percentage of overall
government debt has been decreasing and at the time of writing it has
stabilised just above 40%. However, the demand for real rate assets
remain strong, as it is clear from the fact that about 70% of the corporate debt market is also indexed to inflation. According to Barclays
Capital (2012), the total stock of inflation-linked bonds in Israel was
NIS405 billion at the end of 2011, split between government inflationlinked bonds (NIS170 billion) and corporate inflation-linked bonds
(NIS235 billion).
Israeli Government inflation-linked bonds come in two flavours,
both linked to the Consumer Price Index (CPI). The Galil bonds have
both principal and interest indexed to the CPI and floored. Their
original maturities ranged between 2 years and 30 years, but the
longest outstanding issue has (at the time of writing) only 12 years
to maturity. Since 2006, a new type of inflation-linked bond has been
issued (also up to 30 years maturity), the main difference being
the absence of principal and coupon floors. This is partly due to
the historical large fluctuations of inflation rates in Israel, and the
governments reluctance to sell such deflation floors.
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CONCLUSIONS
Several of the most advanced inflation-indexed markets are to be
found in emerging countries.
Indexation pioneers include Brazil and Israel, which issued their
first linkers in 1964, and Chile, which started issuance in 1967. To put
the timeline into perspective, this was about 20 years earlier than the
occurrence of similar developments in the UK, the first developed
country to start an inflation-linked programme in the modern era.
For many emerging markets, the issuance of inflation-linked
bonds was a piece of a much larger jigsaw. These countries had introduced a new inflation-linked accounting measure, which affected all
the aspects of economic activity from linking salaries to inflation to
mortgage and corporate debt. Indeed, these measures were aimed
at mitigating the effects of chronically high inflation, partly caused
by a structuralist economic approach, where the government subsidised industries, creating chronic deficit and high inflation in the
process. Indeed, inflation-linked bonds were one of the few viable
options for funding long-term local currency debt in these economic
circumstances.
In the 1990s, the focus of policymakers in emerging countries
turned to lowering and controlling inflation. After the failure of currency pegs in Mexico, Argentina and Brazil, inflation-targeting monetary policies were adopted in these countries and others. Their success had important consequences. The drop in inflation was coupled
with an anchoring of inflation expectations around the inflation target. Lower and more stable inflation expectations and less volatility
in inflation drove down market inflation break-evens significantly
across most countries. This initiated a de-indexation phase in several emerging market economies, and in countries such as Brazil,
Israel and Chile the focus gradually moved to the development of
the nominal yield curve. However, this did not mean the beginning
of the end of inflation markets. On the contrary, the rapid growth
and social development experienced by most developing countries
since the 2000s has seen the evolution of modern pension and insurance systems, which, together with important changes in the regulatory framework, has gradually created a large structural demand for
long-dated real return assets. Consequently, governments have been
reshaping their inflation-linked debt, through issuance or auctions,
eg, by extending duration in order to better match pension funds
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demand. This, together with increased market liquidity and simplified offer processes, has helped to lower long-term real yield and also
contributed to the development of a corporate inflation-linked bond
market in countries such as Israel, Brazil, South Africa and Chile,
whereas such markets remain limited in developed countries.
When it comes to inflation indexation, it is interesting to note how
the path followed by developed countries (the UK starting issuance
of inflation-linked debt in 1981, followed by the US in 1997 and
France in 1998) is quite different. These countries developed a nominal debt market first, and for them indexation was motivated by
the desire to capture the inflation risk premium, and thus achieve
better funding rates, rather than being dictated by chronic high inflation. Indeed, for most developed countries, the growth of sovereign
inflation-linked bonds has been exponential but occurred in a low
and stable inflation environment (with the exception of the UK). On
the demand side, the evolution of the market in developed countries
was driven in part by regulations that encouraged pension funds and
insurance companies to hedge their inflation-sensitive liabilities.
Despite the difference in historical and economic paths between
developed and emerging markets, at the time of writing we are witnessing a certain degree of convergence in global fixed income markets. After establishing a liquid nominal curve first, developed countries have, since the late 1990s, established or completed the real
curve as well. Conversely, several emerging countries, for which
indexation has traditionally been the only viable long-term funding option, have also established (or extended the maturity of) their
nominal programmes. In all cases, rising structural demand for
inflation-linked products (from pension funds and insurance companies) has been supporting indexation, often being a major cause
for issuance (eg, in South Africa and Thailand). We expect this to
continue to be a positive factor globally, and for Asian countries (eg,
India) in particular.
The gradual integration of emerging countries inflation markets
into the overall market is translating into more complex flows at the
global level, with new products (such as inflation focused mutual
funds and exchange-traded funds) being engineered in order to meet
new demand. Strong global demand for inflation-linked products
has translated into lower real rates, but more complex flows can also
plant the seeds for higher volatility, as the new sources of demand
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can be more variable, especially compared with the traditional market activities of domestic pension funds and insurance companies.
Other macroeconomic factors, such as the rising volatility of commodity prices (an important factor, especially for emerging countries price baskets), add to the uncertainty, especially in the short end
of the inflation curve. Furthermore, the monetary policies adopted
in response to the 20089 recession, ie, exceptionally low rates and
quantitative easing, might come into question in the future and also
raise uncertainty about the future path of inflation globally.
All of these points make us believe that inflation markets will offer
opportunities as well as investment solutions to these very topical
issues. And, in this respect, the long history of inflation indexation
in emerging countries may indeed make them better prepared for
what is likely to be an uncertain future.
1
The UK Government started issuing inflation-linked bonds in 1981, the US Treasury started
in 1997 and France followed in 1998.
See Capital Indexed Bonds at http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/

53629.pdf.
In 2010, State Street Global Advisors launched an ETF tracking the Deutsche Bank Global Governments Ex-US Inflation-Linked Bond Capped Index. This index measures the total return
of inflation-linked government bonds of both developed and emerging market countries outside the US. As of May 31, 2010, the index was composed of 17 government inflation-linked
benchmark indexes: Australia, Brazil, Canada, Chile, France, Germany, Greece, Israel, Italy,
Japan, Mexico, Poland, South Africa, South Korea, Sweden, Turkey and the UK.
The National Treasury of Brazil issues long-maturity (10Y, 30Y and 40Y) inflation-linked
bonds.
The exact calculation can be found in Federal Government Bonds: Methodology for Calculating Federal Government Bonds Offered in Primary Auctions at http://www.tesouro.gov.br/.
In most countries the inflation index is published with a lag. In addition, the index used for
settlement of inflation-linked bonds typically contains a lag and/or is an interpolated value
between lagged inflation index values.
Chile has had a floating exchange rate regime since 1999, but intervenes if the exchange rate
level deviates significantly from its equilibrium.
The INPC is released twice a month, on the 9th (accruing inflation between the 15th of the
month and the last day of the previous month) and on the 24th (accruing inflation between
the 1st and the 15th of the current month).
Foreign investors are not subject to withholding taxes or any other Mexican taxes (Barclays
Capital 2012).
10 See The Functions of the Bank of Israel at http://www.bankisrael.gov.il/abeng/1-4eng.htm.
REFERENCES
Barclays Capital, 2012, Global Inflation-Linked Products: A Users Guide, Barclays

Capital Inflation-Linked Research, May.
504
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perrucci 2012/7/11 17:12 page 505 #527
Barnea, E., and N. Liviatan, 2008, The Chronic Inflation Process: A Model and Evidence
from Brazil and Israel, Journal of Economic Policy Reform 11(2), 151162.
Bnaben, B., and H. Cros, 2008, Global Inflation Derivatives Markets, in B. Bnaben and
S. Goldberg (eds), Inflation Risks and Products: The Complete Guide, Chapter 11 (London: Risk
Books).
Bernanke, B. S., 2005, Inflation in Latin America: A New Era?, Speech at the Stanford Institute for Economic Policy Research Economic Summit, Stanford, California,
February 11, URL: http://federalreserve.gov/boarddocs/speeches/2005/20050211/.
Chow, K., and R. Segreti, 2008, Inflation Products in Emerging Markets, in B. Bnaben
and S. Goldberg (eds), Inflation Risks and Products: The Complete Guide, Chapter 10 (London:
Risk Books).
Deacon, M., A. Derry and D. Mirfendereski, 2004, Inflation Indexed Securities (Chichester:
Wiley Finance).
Fisher, I., 1911, The Purchasing Power of Money (New York: Macmillan).
International Monetary Fund, 2004, Chile: Selected Issues, IMF Country Report 04/292.
Kaufman, G. G., T. H. Krueger and W. C. Hunter, 1999, The Asian Financial Crisis: Origins,
Implications and Solutions (Springer).
Osorio, C., and F. D. Unsal, 2011, Inflation Dynamics in Asia: Causes, Changes, and
Spillovers from China, IMF Working Paper WP11/257.
Poirson, H. K., 2007, Financial Market Implications of Indias Pension Reform, IMF
Working Paper WP/07/85.
Shiller, R., 1998, Indexed Units of Account: Theorey and Assessment of Historical
Experience, Cowles Foundation Discussion Paper 1171.
Tesouro Nacional, 2011, Optimal Federal Public Debt Composition: Definition of a LongTerm Benchmark, URL: http://www.tesouro.fazenda.gov.br/.
Tesouro Nacional, 2012, Federal Public Debt: Annual Borrowing Plan 2012, URL: http://
www.tesouro.fazenda.gov.br/.
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Index
(page numbers in italic type relate to tables or figures)
A
ABP, 19
additive year-over-year inflation
swap, 126
affine term structure models,
21516
real and nominal, 24850
see also models
airports, 746
see also infrastructure assets
alternative calibration exploiting
currency analogy, 16970,
1734
American International Group
Commodity Index
(AIGCI), 18
arbitrage trade, 4712
Archer Daniels Midland
Company, 85
Art Market Research indexes, 427
assessment of liquidity in
inflation swaps and
options, 163
asset-class models to factor
models, 4026
asset prices:
and inflation, 27796
and money-neutrality
hypothesis, 2845
asset returns:
and inflation, 89
equilibrium-based
theories of, 3069
stock-price-based theories
of, 30913
and lagged inflation, 48
asset and sector rotation,
hedging through, 32546,
333, 334, 337, 341, 343
and broad asset classes,
impulse response, 33642
and core asset classes,

and data, 3312
and investment implications,
3425
and model specification,
32831
and previous research,
learning from, 3268
asset swaps (ASWs) and
inflation asset swaps,
12833, 129
and effect of interest rate,
spread and inflation
break-even changes, 132
TIPS, 130
Australia, mining investments
in, as percentage of GDP,
36
B
Bank of Canada, 196
Monetary Policy Report
(2011), 192
Bank of England, 196
Inflation Report (2011), 192
Bank of Finland, 196
Bank of Israel, 183, 500
interest-rate forecast, 183
Bank of Japan, 263
Bankers Trust Commodity Index
(BTCI), 18
Bernanke, Ben, 185, 484
Blue Chip Economic Indicators
Survey, 225, 226
bond prices in discrete time,
2389
bonds, inflation-linked, 1035,
11625
non-government, 1235, 124
pricing distortions and
opportunities in, 11623
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and lack of investment

index sponsorship, 1212
and market pricing driven
by real rates levels, 1201
and other inefficiencies,
122
and risk-adjusted inflation
break-even rate, 1223
see also TIPS
bonds, investment-linked, asset
allocation with, 11316
bonds, n-period expected return,
23940
busted convertible securities,
96100
C
California Public Employees
Retirement System
(CalPERS), 417
Chase Physical Commodity
Index, 18
Chicago Fed National Activity
Index, 354
Chicago Mercantile Exchange,
413
Church and Dwight, 94, 95
Colliers International Luxury
Residential Index, 426
commodities:
as best-performing core
asset-class hedge, 335
and growth, 337
and inflation, 2530, 26
misunderstood nature of, 16
and pensions, as investment
strategy, 41517
prices of, and Chinese
non-food inflation, 29
prices of, and European core
inflation, 28
prices of, and US core
inflation, 28
risky nature of, 15
see also commodity investing
commodities shocks, and
inflation, 1323
commodity investing, 3740

and growth, 3940
and inflation, 379
as inflation hedge, 212
mainstream status of, 1920
see also commodities
commodity price indexes:
evolution of, 1819
first investable, 1618
and futures, 1416
growth in, 1819
commodity prices:
and inflation and monetary
policy, 25575
econometric findings,
26973
in financial crisis, 2624
overshooting, 2679
targeting, 25762
Commodity Research Bureau, 27
and commodity price
indexes, 14
comparison between historical
and implied volatility,
1646, 166
constant-volatility affine AR(1)
models, 216, 240
see also models
Consumer Price Index (CPI)
(European Harmonised),
413
Consumer Price Index (CPI)
(US), 17, 43, 108, 272
Colliers International Luxury
Residential Index
compared to, 426
distribution of annualised
six-month rates, 49
and food and energy, 31
Higher Education Price Index
compared to, 426
Liv-ex Fine Wine Index
against, 427
Consumer Price Index All
Urban Consumers (CPI-U)
(US), 5, 5, 369
and stock performance, 418
508
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INDEX
convertible securities, busted

96100
Copernicus, Nicolaus, 278
core projection models, 1938
different types of, 1956
and parsimony, 193
and policy reaction function,
1968
and robustness to policy
errors, 1945
top-down approach to, 1934
cost-of-living adjustment
(COLA), 3901, 397
CPI, see Consumer Price Index
Credit Suisse Commodity
Benchmark (CSCB), 18, 37
currency analogy, 16770, 168
alternative calibration
exploiting, 16970, 1734
JarrowYildirim model,
1679, 168, 1734
Czech National Bank:
Inflation Report (2011), 192
three-month Pribor rate
forecast, 183
D
Daiwa Physical Commodity
Index (DPCI), 18
deflation/inflation debate in US,
4746
see also inflation
developed-market equities:
equity investing and
inflation, sensible
approach to, 335
and growth versus value
styles, 340
sector indexes, 33840
development of zero-coupon
inflation options, 1602
directional trade, 4701
Dow Jones, and commodity
price indexes, 14, 18
Dow Jones Industrial Average,
445
and break-even inflation, 444
Dow Jones UBS Commodity

Index (DJUBSCI), 18, 20,
37
E
Economist, The, 14
emerging markets:
developed versus, forecasting
inflation for, 3656
developed versus, size of
inflation-linked debt, 481
federal public debt, Brazil,
492
food inflation in, 365
higher mean inflation in, 302
inflation in, as percentages, 31
inflation indexation and
products in, 479504
evolution of: Asia, 4869
evolution of: Latin America,
4826
inflation-linked products in,
489501, 490
Brazil, 4917
Chile, 4978
Israel, 5001
Mexico, 498500
inflation rates, Brazil, 494
inflation rates, Israel, 501
and inflation targeting, 260
largest inflation in, 31
money markets, bonds and
equities, 3412
price indexes, Brazil, 493
sovereign inflation-linked
debt, Chile, 495
year-on-year inflation rate in,
480
energy and water utilities, 712
equilibrium-based theories of
inflation and asset returns,
3069
equities:
developed-market, as
worst-performing core
509
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and emerging markets,

money markets and
bonds, 3412
and pensions, as investment
strategy, 41718
equityinflation puzzle, 30520
and equilibrium-based
theories of inflation and
asset returns, 3069
and high- and low-inflation
differences, 31920
and stock-price-based
theories of inflation and
asset returns, 30913
and stock returns, empirical
evidence, 31320
equity investing and inflation,
sensible approach to,
85100
and busted convertible
securities, 96100
and leveraged companies
and deleveraging
mechanisms, 906, 92, 93
and real-estate companies,
8990
and royalty companies, 868
and spread-based companies,
889
equity investments:
prices, 7985, 80, 81
equity prices:
and inflation, 7985, 80, 81,
2879
and expectations on
prices, 835
and interest rates and
costs, 823
equity returns:
expected versus
unexpected, 3045
and Fishers hypothesis,
3034
nominal and real, 300
nominal and real annual, 301
European Central Bank, 25, 33,

151, 185, 256, 278, 393
European Harmonised Index of
Consumer Prices, 413
excess inflation, summary
sample statistics
(19472011), 407
excess inflation, summary
subsample statistics, 409
exchange rates, and inflation,
2867
expectation hypothesis and
no-arbitrage models,
21213
expected inflation:
and expectation hypothesis
and no-arbitrage models,
21213
implications for investors
and policymakers, 2335
versus risk premium, 233
and term structure of interest
rates, 20951
and term structure
modelling, basic concepts
of, 20920; see also models;
term structure modelling
and probability measures,
21112
and term structure models,
literature on, reviewed,
2249
versus unexpected, 3045
see also inflation
F
factor framework, modelling
inflation in, 40611
factor volatilities and correlation
matrix, 409
Feldman, Jay, 27
final-goods inflation, 2647
Financial Times, 14
first investable commodity price
index, 1618
Fisher, Irving, 299, 3034
and unemployment, 353
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INDEX
floors in inflation-linked
government bonds, 1567
food inflation, 3623, 362
forecasting inflation:
in developed versus
emerging markets, 3656
practical models for, 35167,
352, 354, 358, 359
in developed versus
and food, 3623, 362
fundamental, bottom-up,
35663
fundamental, top-down,
3516
and household energy,
3612
and petroleum, 35960
and shelter, 360
technical time-series,
3635
technical time-series models
for, 3635
forecasting and policy analysis
systems (FPAS), 18693
and forecasting horizons,
different models for,
1878, 187
major components in, 18891,
188
forward inflation curve:
granular, 1545
monthly, 1506
yearly, 150
FPAS, see forecasting and policy
analysis systems
Franco-Nevada, 86, 87
fundamental models for
forecasting inflation:
bottom-up models, 35663
top-down models, 3516
futures, and commodity price
indexes, 1416
G
global financial crisis, 345, 369,
460
and inflation market, 4445

inflation markets since, 4445
and inflation volatility, 439
and low yields from, 428
monetary policy in, 2624
Goldman Sachs Commodity
Index (GSCI), 18
Gordon growth model, 309
Gordon, Myron, 309
government-issued
inflation-linked bonds,
41213
granular forward inflation
curve, 1545
Great Inflation, xix, 277, 282,
2878
and portfolio shift, 292, 293,
295
Great Moderation, 4, 188
Great Recession (20089), see
global financial crisis
growth:
and commodities, 337
and commodity investing,
3940
forecasts of, embedded in
equity and industrial
commodity prices, 9
H
hard awakening of risk
management in inflation
option books, 15860
hedging:
assets for, and an efficient
frontier, 3814
ASW strategy, 458, 458
commodity investing as, 212
and developed-market
equities, as
worst-performing core
effectiveness of, and
inflation-sensitivity, 478
with illiquid real-estate
investments, 635
511
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by pension funds and

insurance companies,
4412, 441
and real-estate investments,
458
through asset and sector
rotation, 32546, 333, 334,
337, 341, 343
and data, 3312
and investment
implications, 3425
32831
learning from, 3268
and zero-coupon inflation
swaps, 457, 458
Higher Education Price Index,
426
historical and implied volatility,
comparison between,
1646
household energy inflation,
3612
I
IBM, 15
implied and historical volatility,
comparison between,
1646
income, nominal and real, effects
of taxation on, 28995
index, proxy, modelling assets
and liabilities with, 400
indexation lag, 2312
indexation of pension plans,
3902, 391
indexed bonds, real bonds and
TIPS, 2425
inflation, 27984
annual rates of:
Brazil, 302, 494
Germany, 4, 302
Japan, 4, 302
Mexico, 302
UK, 4
US, 4, 302
annual, and policy targets, in
Brazil, 494
Art Market Research indexes
versus, 427
and asset prices, 27796
and money-neutrality
hypothesis, 2845
and asset returns, 89
equilibrium-based
theories of, 3069
stock-price-based theories
of, 30913
basic concepts of, 56
break-even, for, 10-year TIPS,
4078, 408
break-even, versus Dow
Jones Industrial Average
(2011) 444
in China, non-food, and
commodity prices, 29
and commodities, 2530, 26
and commodities shocks,
1314
commodity investing as
hedge against, 212; see
also inflation-sensitive
assets
and commodity investments,
379
compensation: expectation
and risk premium, 45962,
460
and CPI, see Consumer Price
Index
core, commodity prices
correlation with, 30
core, and money supply, 355
cumulative, 371
derivatives, 126, 41314
derivatives, with linear
payouts, 1258
different causes of, 68
duration, and real rate
duration, 399
512
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INDEX
and equity investments,

79102
prices, 7985
sensible approach to,
85100
and equity prices, 2879
and equity, puzzle
concerning, see
equityinflation puzzle
and equity returns, 299321
and Fishers hypothesis,
3034
nominal and real, 300
nominal and real annual,
301
European, and commodity
prices, 28
excess, summary sample
statistics (19472011) 407
excess, summary subsample
statistics, 409
and exchange rates, 2867
expected:
implications for investors
and policymakers, 2335
versus risk premium, 233
and term structure of
interest rates, 20951
versus unexpected, 3045
as feared economic
phenomenon, 137
on final goods, 2647
food, 3623, 362
government-issued bonds
linked to, 41213, 412
hedging for, through asset
and sector rotation,
32546, 333, 334, 337, 341,
343
and data, 3312
and investment
implications, 3425
32831

learning from, 3268
hedging strategies for,
tailoring, 3846
history and outlook, 36973
household energy, 3612
and indexation and products
in emerging markets,
479504
evolution of: Asia, 4869
evolution of: Latin
America, 4826
and infrastructure assets,
6977
airports, 746
defining, 6970
energy and water utilities,
712
impact on, 701
tollroads, 724, 73
and investable commodity
indexes, 1323
lagged, and asset returns, 48
market models of, 1702
markets linked to, 10335
bonds, 1035, 11625
TIPS, 10513, 111, 113, 115
markets, portfolio managers
perspective on, 43576; see
also inflation markets
measures of, 2814
modelling, in factor
framework, 40611
as monetary phenomenon,
27980
and monetary policy, 323
and monetary policy and
commodity prices, 25575
econometric findings,
26973
and final goods, 2647
in financial crisis, 2624
overshooting, 2679
super-cycle possibility,
257
targeting, 25762
and nominal interest rates,
2856, 285
513
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and non-monetary factors,

2801
as non-stationary stochastic
process, 4479, 448
options, 147
options, historical
perspective on, 15662
options, US-traded, 41314,
414
and pensions, 389420
and asset-class and factor
models, 4026, 404
brief history, 3924
contributions affected by
liability changes, 3947
correlation matrix, 401
investment strategies for,
see investment strategies
and risk-factor correlation
matrix, 405
surplus in, risk-factor
loadings for, 405
surplus variance
decomposition, 401
variance decomposition,
401
and variance
decomposition by risk
factor and factor-model
surplus volatility, 406
periods of, a brief history,
3924
and personal consumption,
282
petroleum, 35960
protecting insurance
portfolios from, 36988,
374
asset allocation details, 376
and capital adequacy/
credit rating, 385
and decomposition of
variance of economic
value, 377
and different assets in
inflationary periods,
37981
and economic variance

decomposition, 3758
and efficient investment
frontiers for economic
value, 383
and hedging strategies,
tailoring, 3846
history and outlook,
36973
and impact on insurers
equity value, 3789, 378
and inflation-hedging
assets and efficient
frontier, 3814
and insurers equity value,
383
and investment income,
386
and liabilities, long-tail
versus short-tail, 385
liability composition
details, 377
and life insurance
companies, 3867
and risk to property and
casualty companies, 3734
and risk tolerance, 386
and risk and return of
various asset classes, 382
simulation approach,
3745
protection, 4856, 52
optimal portfolio
allocation for, 57
and portfolios, balanced
approach to, 5661
success rate, 50, 52
tactical asset selection for,
4854
effectiveness of, 4851
robustness of, 514
tactical portfolio allocation
for, 546
and real-estate investments,
4368
and hedging, 458
514
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INDEX
and real stock prices, 387

recycling, from project
finance deal to pension
fund, 143
risk of, for life insurance
companies, 3867; see also
insurance portfolios
risk of, for property and
casualty companies, 3734
risk premium, 10-year, 460
risk premium, 10-year
(estimate) 461
sensitivity, and hedge
effectiveness, 478
shelter, 360
and sovereign debt, 438, 438,
491, 497, 498
and stock returns, empirical
evidence, 31320
hedge effectiveness,
31317
high- and low-inflation
differences, 31920
tactical asset allocation,
31719
tactical asset allocation in
relation to, 31719
tailoring hedging strategies
for, 3846
and term structure models,
literature on, reviewed,
2249
and ultra-high-net-worth
(UHNW) investors, 42334
definition, 424
and legacy and time
horizon, 425
and leverage, 4323
and liabilities, 5256
and real-asset life cycle,
430
and real assets, 4289
and risks and returns,
4302, 432
and unemployment, 7, 7,
3526 passim, 352
US, 370
US, annual rate of, 393
and US banking system, 6

US, and commodity prices, 28
US, rolling annual
(19482010) 380
US, stability of, 369
US, strong autoregressive
properties of, 334
year-on-year, Asia, 486
inflation asset swaps, 12833,
129
and effect of interest rate,
spread and inflation
break-even changes, 132
TIPS, 130
see also inflation swaps
inflation cashflows of a
structured note, 144
inflation/deflation debate in US,
4746
inflation demand, 43942
inflation derivatives with linear
payouts, 126
inflation expectation versus risk
premium, 233
inflation forecasting:
in developed versus
practical models for, 35167,
352, 354, 358, 359
in developed versus
and food, 3623, 362
35663
3516
3612
and shelter, 360
3635
technical time-series models
for, 3635
inflation-linked bonds, 1035,
11625
floors in, 1567
non-government, 1235, 124
515
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and lack of investment
index sponsorship, 1212
and market pricing driven
by real rates levels, 1201
and other inefficiencies,
122
and risk-adjusted inflation
break-even rate, 1223
inflation-linked markets, 10335,
126
bonds, 1035, 11625
non-government, 1235,
124
characteristics of, 106
and investment-linked
bonds, 11316
TIPS, 10513, 111, 113, 115
inflation markets, 437
carry calculations concerning,
462
and demand, 43942
and global financial crisis,
4445
and global financial crisis
(20089), 4445, global
financial crisis
and impact of hedging by
pension funds and
insurance companies,
4412, 441
and inflation compensation:
expectation and risk
premium, 45962
and macroeconomic models,
44755, 452
growth and real rates,
4534
monetary policy, 4523
scenario analysis, 4545,
455
and option models, 4659
portfolio managers
perspective on, 43576; see
also inflation markets
and pricing and

compensation in swap and
cash market, 4559
and pricing models, 45569
role of market makers in,
4424
and seasonality, 4625, 463
and sovereign debt, 438
strategies, in action, 46972,
471, 472; see also
investment strategies
examples: arbitrage trade,
4712
examples: directional
trade, 4701
and supply, 4389
inflation option books, hard
awakening of risk
management in, 15860
inflation options:
at-the-money, 147
historical perspective on,
15662
and floors in
inflation-linked
government bonds, 1567
and hard awakening of
risk management in
inflation option books,
15860
and structured inflation
notes market and
year-on-year inflation
options, 1578
and zero-coupon inflation
options, 1602
market, understanding:
year-on-year, 162
zero-coupon, 1623, 163
models, 16772
JarrowYildirim, and
168
macroeconomic, 167
US-traded, 41314, 414
zero-coupon, 1602, 1623,
163
516
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INDEX
inflation premium and real-term

premium, 2458
inflation products, 4467
in emerging markets, 489501
Brazil, 4917
Chile, 4978
Israel, 5001
Mexico, 498500
see also inflation markets:
strategies, in action;
investment strategies
inflation-protected portfolio,
balanced approach to,
5661
inflation-sensitive assets, 311
and basic concepts of
inflation, 56
and evaluation of assets, 34
as new asset class, 911
and other instruments, 10
see also inflation
inflation-structured notes:
and retail demand, 1434
year-on-year, 1578, 157
inflation supply, 4389
inflation swaps:
different market conventions
for, 146
historical perspective on,
13844, 139
investment banks:
managing inflation risk,
1423
pension funds: hedging
liabilities inflation risk,
13842; see also inflation
asset swaps
retail demand and
inflation-structured notes,
1434
and historical and implied
volatility, comparison
between, 1646
market, understanding,
14456
and monthly forward
inflation curve, 1506
year-on-year, 14550
year-on-year, complexity
adjustments in, 14550
and yearly forward
inflation curve, 150
zero-coupon, 1445
and options, assessment of
liquidity in, 163
and options, understanding
and trading, 13774, 165,
166
and currency analogy,
16770; see also currency
analogy
and development of
zero-coupon inflation
options, 1602
and hedging year-on-year
swap with two
zero-coupon swaps, 148
and historical and implied
volatility, comparison
between, 1646
and inflation-structured
notes, 1578, 157
zero-coupon, 1445
inflation targeting and emerging
markets, 260
inflation targeting and modern
monetary policymaking,
25762
inflationary periods, brief
history of, 3924
infrastructure assets:
airports, 746
defining, 6970
energy and water, 712
high leverage on,
implications of, 767
and inflation, 6977
impact of, 701
tollroads, 724, 72
insurance companies, impact of
inflation hedging by,
4412, 441
insurance portfolios:
protection of, from inflation,
36988, 374
asset allocation details, 376
517
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and capital
adequacy/credit rating,
385
and decomposition of
variance of economic
value, 377
and different assets in
inflationary periods,
37981
and economic variance
decomposition, 3758
and efficient investment
frontiers for economic
value, 383
history and outlook,
36973
and impact on insurers
equity value, 3789, 378
assets and efficient
frontier, 3814
strategies, tailoring, 3846
and insurers equity value,
383
and investment income,
386
and liabilities, long-tail
versus short-tail, 385
liability composition
details, 377
and life insurance
companies, 3867
and risk tolerance, 386
and risk and return of
various asset classes, 382
simulation approach,
3745
interest, Fishers theory of, 299,
3034
interest rates:
Bank of Israel forecast
concerning, 183
forecasts of, drivers of change
in, 200
and inflation break-even
changes, effect of, 132
nominal, and inflation, 2856,

285
Reserve Bank of New
Zealand, 90-day forecast
concerning, 181
rising, impact of, 823
and spread changes, effect of,
129
term structure of, and
expected inflation, 20951;
see also expected inflation
investable commodity indexes,
and inflation, 1323
investment-linked bonds, asset
allocation with, 11316
investment strategies, 41118
commodities, 41517
equities, 41718
government-issued
41213, 412
inflation derivatives, 41213
see also inflation markets:
strategies, in action;
inflation products
investments:
equity, and inflation, 79102
long- versus short-term, 295
mining, as percentage of GDP
(Australia) 36
real-estate, 4368, 64
illiquid, 635
Iran Revolution, 13
J
Japan, lost decade in, 3
Jarrow, Robert, 157
JarrowYildirim models and
168, 1734
JP Morgan Commodity Futures
Index, 18
JP Morgan Commodity Index
(JPMCI), 18
JP Morgan Emerging Local
Markets Index Plus
(ELMI+), 332
518
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INDEX
JP Morgan Emerging Market

Bond Index Plus (EMBI+),
332
L
leverage, 4323
along real asset value chain, 433
of companies, and deleverage
mechanisms, 906, 92, 93
high, implications of, on
infrastructure assets, 767
liabilities, long-tail versus
short-tail, 3846
life insurance companies,
inflation risk for, 3867; see
also insurance portfolios
linear payouts, inflation
derivatives with, 1258,
126
liquidity effects in TIPS, 22931
liquidity in inflation swaps and
options, 163
Liv-ex Fine Wine Index, 427
Livingston Survey, 225, 408
M
market makers, role of, 4424
market models of inflation,
1702
markets, inflation-linked,
10335, 126
bonds, 1035, 11625
non-government, 1235,
124
and investment-linked
bonds, 11316
TIPS, 10513, 111, 113, 115
Merrill Lynch Energy and
Metals Index (ENMET), 18
mining investments, as
percentage of GDP
(Australia) 36
modelling inflation in a factor
framework, 40611
models:
affine term structure, 21516
affine term structure, real and
nominal, 24850
asset-class to factor, 4026
constant-volatility affine
AR(1), 216, 240
how used, 199
for inflation forecasting,
35167, 352, 354, 358, 359
in developed versus
and food, 3623, 362
35663
3516
3612
and shelter, 360
3635
and interest-rate forecast,
drivers of change in, 200
and latent factors and
macroeconomic variables,
21920
multi-factor, of the short rate,
21415
multivariate, for near-term
forecasting, 2012
no-arbitrage, and expectation
hypothesis, 21213
option, and inflation markets,
4659
and pensions, 4026
pricing, and inflation
compensation in swap and
cash market, 4559, 456
projection, core, 1938
different types of, 1956
and parsimony, 193
and robustness to policy
errors, 1945
top-down approach to,
1934
519
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real term structures, literature

on, reviewed, 2249
of real and nominal-term
structures, 2213, 228
role of, in modern monetary
policy, 179206
Bank of Israel interest rate
forecast, 183
Czech National Bank
three-month Pribor rate
forecast, 183
forecast production
process, 1913
forecasting and
policy-analysis systems,
18693
how used, 1989, 199
Norges Bank policy rate
forecast, 182
Reserve Bank of New
Zealand, 90-day interest
rate forecast, 181
Riksbank (Sweden) repo
rate, 182
single-factor, of the short rate,
313
stochastic volatility, 21619
stylised, semi-structural flow,
for open economy, 2025
term structure, basic concepts
of, 20920; see also term
structure modelling and
probability measures,
21112
modern monetary policy:
role of models in, 179206
Bank of Israel interest rate
forecast, 183
forecast production
process, 1913
forecasting and
policy-analysis systems,
18693
how used, 1989, 199
Norges Bank policy rate
forecast, 182
projection, core, 1938
Reserve Bank of New

Zealand, 90-day interest
rate forecast, 181
Riksbank (Sweden) repo
rate, 182
monetary policy, and inflation,
323
money-neutrality hypothesis,
2845
money supply, and core
inflation, 355
monthly forward inflation
curve, 1506
multi-factor models of the short
rate, 21415
see also models
multiplicative inflation swap,
126
multivariate models for
near-term forecasting,
2012
N
neutral money, 278
Newmont Mining, 824, 87
Nixon, Richard, 13
nominal interest rates, and
inflation, 2856, 285
nominal and real income, effects
non-government
1235, 124
Norges Bank, 183, 196, 198
policy rate forecast, 182
O
OAPEC oil embargo, 13
oil-price shocks, 13, 30, 4734,
474
Ontario Teachers Pension Plan,
19
operating costs, rising, impact
of, 823
Oppenheimer Commodity
Strategy Total Return
Fund, 19
520
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INDEX
Oppenheimer Real Asset Fund,

19
optimised investment portfolios,
historical performance of,
59
overshooting, a theory of, 2679
P
pension funds, impact of
inflation hedging on,
4412
pension plans:
California Public Employees
Retirement System
(CalPERS), 417
contributions to, affected by
liability changes, 3947
discount curve and other
duration contributions, 398
and asset-class and factor
models, 4026, 404
correlation matrix, 401
investment strategies for,
see investment strategies
modelling, in factor
framework, 40611
surplus variance
decomposition, 401
variance decomposition,
401
inflation indexation of, 3902,
391
and inflationary periods,
brief history of, 3924
and liabilities, inflation
sensitivity of, 3989
and liabilities, interest-rate
sensibility of, 3978
and risk budgeting, 399402
and risk-factor correlation
matrix, 405
surplus in, risk-factor
loadings for, 405
US, private, example of, 397
and variance decomposition

by risk factor and
factor-model surplus
volatility, 406
Peoples Bank of China, 25
petroleum inflation, 35960
PGGM, 19
Phillips, William, 353
portfolio allocation:
optimal, 57, 60
tactical, 546
property types, different,
inflation-sensitivity of,
613
proxy index, modelling assets
and liabilities with, 400
R
real-asset life cycle and value
chain, 430
real-asset value chain, risks and
returns along, 432
real bonds, indexed bonds and
TIPS, 2425
real-estate investments, 64,
8990
home versus consumer
prices, 415
illiquid, inflation hedging
with, 635
and inflation, 4368
and hedging, 458
public and private, and other
real assets, 41415
real and nominal income, effects
real and nominal-term
structures, modelling,
2213
real-term premium and inflation
premium, 2458
real yields versus zero-coupon
TIPS yields, 22932
and deflation floor, 232
and indexation lag, 2312
and liquidity effects, 22931
521
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recycling inflation, from

project finance deal to
pension fund, 143
REITs, see real-estate
investments
Reserve Bank of New Zealand,
196
90-day interest rate forecast,
181
retail demand and
inflation-structured notes,
1434
Reuters, 14
ReutersCommodity Research
Bureau Price Index, 17
Riksbank, 182, 183, 196
Monetary Policy Report
(2011), 192
repo rate, 181
risk factor:
and factor-model surplus
volatility, variance
decomposition by, 406
loadings, and variance
decomposition, 410
risk, market price of, 236
risk premium versus inflation
expectation, 233
risks and returns along real asset
value chain, 432
Royal Gold, 86
royalty companies, 868
Russian wheat deal 13
S
single-factor models of the short
rate, 213
see also models
Soss, Neal, 27
sovereign inflation-linked debt,
438, 438, 491, 497
in Chile, 498
spread-based companies, 889
stagflation, 3, 257
Standard & Poors Goldman
Sachs Commodity Index
(SPGSCI), 18, 20, 378, 53
stochastic volatility models,

21619
see also models
stock-price-based theories of
inflation and asset returns,
30913
Gordon growth model
concerning, 309
structured inflation notes
market and year-on-year
inflation options, 1578
structured note, inflation
cashflows of, 144
stylised semi-structural flow
model for an open
economy, example of,
2025
Survey of Professional
Forecasters, 225, 226, 371,
459, 460
T
tactical asset selection:
effectiveness of, 4851
robustness of, 514
taxation, effects of:
on nominal and real income,
28995
on real earnings, 2915
on real rate of interest, 2901
Taylor, John, 259
Taylor rule, 140, 204, 259, 4523,
453
term structure modelling:
and price of risk, 21011, 211
and probability measures,
21112
from short rate to yield curve,
20910
TIPS, see US Treasury Inflation
Protected Securities
tollroads, 724, 72, 73
Treasury Inflation Protected
Securities (TIPS), see US
Treasury Inflation
Protected Securities
522
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INDEX
ultra-high-net-worth investors,
42334
definition of, 424
inflation threat to, 4245
and legacy and time horizon,
425
and leverage, 4323
and liabilities, 4256
and real-asset life cycle,
42930, 430
and real assets, 4289
and risks and returns, 4302,
432
unemployment, and inflation, 7,
7, 3526 passim, 352
United Nations Food and
Agriculture World Food
Price Index, 30
US aggregate bonds, 335
US bond sector indexes, 3378
US Bureau of Labor Statistics, 5,
105, 331
US Federal Reserve, 25, 33, 185,
193, 195, 234, 256, 263, 314
Open Market Committee of,
191, 278
quantitative easing
programmes of, 372
unexpected steps taken by, 369
US Treasury Inflation Protected
Securities (TIPS), 10, 47,
5060 passim, 10513, 111,
113, 115, 2201, 220, 381,
454
indexation lag in, 2312
liquidity effects in, 22931
and real bonds and indexed
bonds, 2425
ten-year, break-even inflation
for, 4078, 408
zero-coupon yields, versus
real, 22932
see also bonds,
inflation-linked
variance decomposition by risk

factor and factor-model
surplus volatility, 406
variance decomposition and risk
factor loadings, 410
Volcker, Paul, xix
W
water and energy utilities, 712
Weimar Republic, xix
Y
year-on-year caps and floors
quotes, 162
year-on-year inflation-structured
notes, 1578
issuance of, 157
year-on-year inflation swaps,
14550
convexity adjustments in,
14750
hedging, 148
yearly forward inflation curve,
150
Yildirim, Yildiray, 157
Z
zero-coupon bond prices, 2368
calculation of, 238
zero-coupon caps and floor
quotes, 163
zero-coupon inflation options,
1602
development of, 1602
zero-coupon inflation swaps,
126, 1445
and hedging strategies, 457,
458, 458
quotes, 1523
zero-coupon TIPS yields versus
real yields, 22932
and indexation lag, 2312
and liquidity effects, 22931
see also TIPS
523
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In the wake of the financial crisis a huge

monetary overhang threatens the major

As a result markets have focused attention on

This book, for the first time, addresses the

Edited by Stefania Perrucci and Brice Benaben

The iron laws of economics have no respect

In Inflation-Sensitive Assets: Instruments and

Inflation Sensitive Assets

The real impacts of inflation and its most

Edited by Stefania Perrucci and Brice Bnaben

Published by Risk Books, a Division of Incisive Media Investments Ltd

Publisher: Nick Carver

To the memory of our fathers, Bernard Bnaben and Pietro Perrucci

About the Authors

INTRODUCTION: MARKETS AND INSTRUMENTS

Investable Commodity Indexes and Inflation: A Brief History

Commodities, Inflation and Growth: Implications for Policy

Inflation and Real Estate Investments

Infrastructure Assets and Inflation

Equity Investments and Inflation

Understanding and Trading Inflation Swaps and Options

RESEARCH AND MACRO PERSPECTIVE

The Role of Models in Modern Monetary Policy

10 Term Structure of Interest Rates and Expected Inflation

11 Monetary Policy, Inflation and Commodity Prices

12 Inflation and Asset Prices

13 Inflation and Equity Returns

14 Inflation Hedging through Asset and Sector Rotation

PRACTICAL INSIGHTS FROM MARKET PARTICIPANTS 349

15 Practical Models for Inflation Forecasting

16 Protecting Insurance Portfolios from Inflation

17 Inflation, Pensions and Liability-Driven Investment Solutions

18 Ultra-High-Net-Worth Investors and the Real Asset Value Chain 423

20 Inflation Indexation and Products in Emerging Markets

About the Editors

About the Authors

ABOUT THE AUTHORS

ABOUT THE AUTHORS

ABOUT THE AUTHORS

In this chapter, we discuss how inflation should be analysed and

Figure 1.1 Annual inflation rates

Source: New Sky Capital.

Figure 1.2 US CPI-U weights of major components (as of December

INFLATION: BASIC CONCEPTS

Figure 1.3 US money and banking system

Deposit into bank

The Federal Reserve

Source: New Sky Capital.

This relation is obviously dynamic, as both money and goods

Figure 1.4 Expectation-augmented Phillips curve

In expectation-augmented Phillips curve models, inflation can

In turn, supply/demand of goods and money, as well as changes in

used, and general conclusions are drawn. However, equity

Furthermore, market prices embed expectations about future

macroeconomic conditions; thus, asset returns are often not

criminate among the different underlying causes of inflation.

different asset classes, but to a different degree (because of

there is an inflation risk premium to buying insurance directly

risk premium, with the latter often dominating the former

sionally be found and/or structured in niche markets where

See http://www.federalreserve.org/ for a more detailed explanation of monetary aggregates.

Investable Commodity Indexes and

COMMODITIES SHOCKS AND INFLATION

INVESTABLE COMMODITY INDEXES AND INFLATION: A BRIEF HISTORY