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Home > Cash Flow Management Checklists > Methods for Dealing with Inflation Risk

Cash Flow Management Checklists

Methods for Dealing with Inflation Risk


Checklist Description

This checklist defines inflation risk and looks at various tools for managing it.

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Definition

Inflation risk can be defined as the risk that the value of physical or financial assets will be eroded by inflation. To protect against that loss, investment managers need to employ one or more of several tried and tested methods.

Investors generally choose investments that offer “insurance” against inflation risk. However, it is important to remember that the overall risk of an investment comes from all risk sources, not just the risk of inflation.

Inflation hedging, which takes into account the co-movements of inflation rates and asset returns from period to period, is one of the most commonly used methods for managing inflation risk. The less influence the rate of inflation has on the real return of an investment, the more effective the inflation hedge will be for the investment. Popular hedges against inflation include property, equities, or commodities that generally have a rising value. Studies of periods of high inflation in the 1970s and 1980s show that, in the mid-term, earnings and the dividend growth rates of equities at least kept pace with inflation.

A popular method for managing inflation risk is the use of inflation protection, which examines the inflation risk of an asset and assesses whether that asset’s real return will be lower than a specific target return (such as zero) at the end of a determined investment period. One downside to using this risk metric is that it only takes into consideration the probability of negative deviations from the target return, but not the amount of them.

The third main method is the inflation swap. Here, the swap involves the use of inflation derivatives (or inflation-indexed derivatives) to transfer inflation risk from one party to another and protect against future liabilities. The derivatives used may be over-the-counter or exchange-traded derivatives.

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Advantages

  • Taking practical steps to deal with inflation risk minimizes both the possibility of real losses and of losses themselves should they occur.

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Disadvantages

  • There is no guarantee that any methods used will protect completely against inflation, and there will always be a degree of risk. The real return of an investment is always uncertain, even for safe assets such as default-free zero-coupon bonds that have a maturity equal to the length of the investment period, even though the nominal cash flow is guaranteed.

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Action Checklist

  • Check that the dividend yields and payout ratios of your chosen method are suitably high and at least in line with inflation.

  • Assess each method thoroughly to determine which is likely to give your assets the best protection against inflation.

  • Run full risk management scenarios that take into account all risks, not just inflation.

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Dos and Don’ts

Do

  • Take into account all risk factors, not just the risk of inflation.

  • Calculate the probability and amount of any shortfall when making inflation-proof investment decisions.

  • Review your decisions if the global economy starts shifting unexpectedly, as you may need to adjust your portfolio for the best protection.

Don’t

  • Don’t assume that traditionally inflation-proof investments such as property are a safe haven. For example, during the credit crunch of 2007–08, the real value of both property and equities fell steeply while inflation rose sharply.

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Further reading

Books:

  • Baumol, William J., and Alan S. Blinder. Macroeconomics: Principles and Policy. 12th ed. Mason, OH: South-Western Cengage Learning, 2011.
  • Brice, Benaben (ed). Inflation-linked Products: A Guide for Investors and Asset & Liability Managers. London: Risk Books, 2005.
  • Brigo, Damiano, and Fabio Mercurio. Interest Rate Models—Theory and Practice, with Smile, Inflation and Credit. 2nd ed. Berlin: Springer-Verlag, 2007.
  • Deacon, Mark, Andrew Derry, and Dariush Mirfendereski. Inflation-indexed Securities: Bonds, Swaps & Other Derivatives. 2nd ed. Chichester, UK: Wiley, 2004.
  • Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. 10th ed. Boston, MA: Pearson, 2012.
  • Walmsley, Julian. The Foreign Exchange and Money Markets Guide. 2nd ed. Wiley Frontiers in Finance Series. New York: Wiley, 2000.

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