The buy- and sell-side have access to a range of products that hedge inflation and pay higher returns in line with higher inflation. They have not been the most popular products for some time, but that is changing. Inflation modelling is crucial for financial firms because it enables them to better understand and manage the risks associated with inflation. Inflation can have a significant impact on various financial instruments, including bonds, equities, derivatives and other investments. By accurately modelling inflation, firms can better forecast future inflation rates, identify potential opportunities or risks and manage their portfolios accordingly.
The buy-side needs to hedge inflation risk – the risk that the value of assets will be eroded by price increases. Fixed income investments particularly bear the brunt of this. For instance, a bond with a 3.5 percent yield will not be enough to match inflation, resulting in a decrease in real returns for investors.
Banks use inflation swaps as a tool to hedge inflation risk in their portfolios. This provides a fixed cash flow for the bank, even if inflation rates rise unexpectedly. Inflation swaps can be customised to meet the specific needs of the bank, allowing them to tailor the swap to their unique inflation risk profile. Banks also use inflation-linked (IL) bonds to help them maintain the real value of their investment in times of inflation.
This paper covers hedging inflation with inflation-linked bonds, an overview of real vs nominal yields and the issues around tackling stubborn inflation.