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Real duration and inflation duration: A cross country perspective on a multidimensional hedging strategy

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  • Fooladi, Iraj J.
  • Jacoby, Gady
  • Jin, Lynn

Abstract

In this study we consider two different duration measures: (i) real duration, which is a measure of a financial instrument (asset or liability) value sensitivity with respect to changes in the real interest rate, and (ii) expected-inflation duration, which is a measure of the instrument value elasticity with respect to changes in the expected rate of general price inflation. These two measures arise because the nominal interest rate is divisible into a real rate and the expected-inflation rate. Thus, when inflation is present, a duration measure depends on the source of the change in the interest rate. We empirically examine cross-country differences and show that in low (negative) nominal rate environments (France and Germany), nominal rates are less responsive to changes in inflation expectations that in a high nominal rate environment (Italy). We show that under-protection of cash flows against inflation may significantly lower the asset value with a sizeable expected-inflation duration. On the other hand, assets with an indexation scheme that over protects against inflation, will be significantly more expensive with nontrivial and negative elasticity with respect to the inflation rate. Finally, we demonstrate that the real and expected-inflation durtion can be utilized to simultaneously hedge the net worth of a firm against adverseimpacts of changes in the real interest rate and changes in the expected-inflation rate.

Suggested Citation

  • Fooladi, Iraj J. & Jacoby, Gady & Jin, Lynn, 2021. "Real duration and inflation duration: A cross country perspective on a multidimensional hedging strategy," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 70(C).
    • Handle: RePEc:eee:intfin:v:70:y:2021:i:c:s1042443120301499
    DOI: 10.1016/j.intfin.2020.101265
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    References listed on IDEAS

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    1. Bierwag, G O & Kaufman, George G & Toevs, Alden L, 1982. "Single Factor Duration Models in a Discrete General Equilibrium Framework," Journal of Finance, American Finance Association, vol. 37(2), pages 325-338, May.
    2. Fisher, Lawrence & Weil, Roman L, 1971. "Coping with the Risk of Interest-Rate Fluctuations: Returns to Bondholders from Naive and Optimal Strategies," The Journal of Business, University of Chicago Press, vol. 44(4), pages 408-431, October.
    3. Jacoby, Gady & Roberts, Gordon S., 2003. "Default- and call-adjusted duration for corporate bonds," Journal of Banking & Finance, Elsevier, vol. 27(12), pages 2297-2321, December.
    4. Gerald O. Bierwag, 1987. "Bond Returns, Discrete Stochastic Processes, And Duration," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 10(3), pages 191-209, September.
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    More about this item

    Keywords

    Duration; Elasticity; Expected-inflation rate; Real rate;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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