Using Inflation-Indexed Securities for Effective Inflation RiskManagement
Inflation-indexed securities are assets whose nominal cashflows explicitly depend on inflation measures. An inflation-linked bond for example adds to a nominal fixed coupon an inflation compensation, which essentially has the effect that the real (inflation adjusted) value of the coupons remains constant. Such a bond offers protection from inflation risk or alternatively insurance from future cash-flows being eaten up by inflation. This risk is most prominent in pensions and the fact why almost all pension funds at least to some extent invest into inflation indexed bonds or more general inflation-indexed securities and derivatives.
At the level of sovereign debt, it has now been recognized for several decades that governments can reduce their borrowing costs by issuing inflation-indexed through avoiding paying a costly inflation risk premium. Indeed, this was the main motivation why the UK and New Zealand first started issuing such securities in the early 1980s, with most major economies following soon. S&P Dow Jones Indices publishes a large variety of inflation linked bond indices at https://www.spglobal.com/spdji/en/index-family/fixed-income/inflation-linked/#overview.
But inflation linked securities fulfill another important function. In pricing such derivatives, the markets process information about future expected levels of inflation. This information can be retrieved from time series of the price data and allows to make even relatively short-term forecasts of inflation levels (that is where monetary policy and macro models often fail). There are many different ways to do this, some better and some worse, but the importance of this aspect has recently been stressed with the introduction of USD Inflation Expectation Index Family by the Inter Continental Exchange in 2022 https://www.ice.com/iba/usd-inflation-indexes. Information about short term future inflation is crucial for investment and insurance.
In the first part of this course, we provide an introduction and overview about the main inflation indexed products and the models that can be used to price them. In this context the course will build on material presented in the now classical textbook “Inflation indexed securities: Bonds, Swaps and other Derivatives” by Deacon, Derry and Mirfendereski Wiley; 2nd edition (May 21, 2004) and the more recent book “Inflation-Linked Bonds and Derivatives: Investing, hedging and valuation principles for practitioners” by James, Leister and Rieger. The second part of the course will be devoted to the question “How to use inflation-indexed products most effectively to hedge inflation risk in investment and insurance”. In this part we will build on some results from academic research, including some of my own, however, intuition and applicability will be emphasized at all times.
