Inflation-Hedging Properties of Real Assets and Implications for Asset–Liability Management Decisions

Abstract

Recent increases in inflation uncertainty have increased investor awareness of the need to hedge against unexpected changes in price levels. Given that the capacity of the inflation-linked securities market is not sufficient to meet the collective demand of institutional and private investors and that the OTC inflation derivatives market suffers from a perceived increase in counterparty risk, investors are now turning to other asset classes to seek inflation protection. Using a vector error correction model that explicitly distinguishes between short-term and long-term dynamics in the joint distribution of asset returns and inflation, the authors show that real estate and commodities have particularly attractive inflation-hedging properties over long horizons and that these properties justify the introduction of these asset classes into pension fund liability-hedging portfolios. These results suggest that novel forms of liability-driven investment solutions, including commodities and real estate in addition to inflation-linked securities, can be designed to decrease the cost of inflation insurance for long-horizon investors.