Hedging Inflation Risk in Indian Financial Market

Hedging Inflation Risk in Indian Financial MarketBy

DR. R. Rangarajan, M.Com., M.Phil., Ph.D., M.B.A., P.G.D.H.O., Associate Professor,

Department of Commerce, University of Madras &

B Srinivasan, IRAS , M.Com,MBA ,Research Scholar ,

University of Madras,Dy. Financial Adviser and Chief Accounts Officer,

Southern Railway

•The Indian economy weathered the global crisis of 2008-09 quite well. But Indian economy has clearly seen a spurt of inflation. •The effect of inflation on Financial market is complex, but it generally leads to an increase.• As inflation increases, the price of the stock, like other prices of goods in the economy, will generally rise as well. •Inflation can have various effects on a company's health. •While some companies may be uninjured or even benefit from inflation, others may be seriously harmed if customers can no longer afford their products. •Even as much of the developed world is still quite some distance from its pre-crisis growth rate, several emerging market economies (EMEs) have made up the lost ground relatively quickly.

Hedging Inflation Risk in Indian Financial Market

•Rising inflation make hard for the investors to estimate their future returns and also safe guard their investments. •Risk is a Characteristic feature of most of commodity and capital markets.•This paper attempts various options available to mitigate and manage this inflation risk through Derivatives.•A derivative Security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate or index of prices (inflation).•Derivative securities provide them a valuable set of tools for managing this risk.•The relevance of the use of Inflation linked Bonds and inflation Swaps to hedge the inflation risk are also brought out in this paper.

Hedging Inflation Risk in Indian Financial Market

Effect of Inflation on Financial market

•Inflation is a state in the economy of a country, when there is a price rise of goods as well as services.• Inflation is not only caused by an increase in money supply but also is caused by the expectation of inflation. •With the increase in inflation every sector of the economy is affected. There is a serious effect in interest rates, exchange rates, investment and last but not the least Stock market. •Prices of stock are determined by the net earnings of the company. •It depends on how much profit the company is likely to make in the near future.• Effect of inflation on the stock market is also evident from the fact that it increases the rates of interest. •If the inflation rare is high interest rate is also high. In this scenario the creditors will have the tendency to compensate for rise in the interest rate. •This compels the debtors to avail loan at a higher rate of interest.

•This affects funds from being invested in the stock markets. •With the high input cost and also lesser market the company’s profit is also bound to be reduced resulting fall of company’s stock prices. •During inflation, this economic growth is unsustainable and the stock markets face an inevitable crash since the Economy managers will have to tighten the rope sooner or later. •The rising prices fuelled by inflation rob the investors since there is no corresponding increase in value. •This has a corresponding implication too. •The company's financials get over-stated as a result of inflation, since the revenue and earnings also rise in the same rate as the inflation and this in combination with additional value which is generated by the company.• when there is a decline in the inflation, the previously inflated earnings and revenues likewise gets deflated.


•When a lot of money is chasing after goods that are fewer in supply, it happens to be a classic case of inflation Then the option is to make money more expensive to borrow. •The excess capital gets removed and the cycle of price increase is slowed down. •Inflation also impacts the future expectations of returns from assets.•In this situation it is quite necessary that investors have to protect their income being affected by adopting suitable strategy. •This paper highlights some of the strategies that can be adopted to hedge against inflation.• Table no. 1 gives the data of inflation and stock market indices during the period from January 2008 to November 2010.


Table -1- Data of inflation and stock market indices during the period from January 2008 to October 2010 .

MONTH 2008 2009 2010

INFLATION SENSEX NIFTY INFLATION SENSEX NIFTY INFLATION SENSEX NIFTY

JAN 5.51 19325.65 5756.35 10.45 9350.42 2854.36 16.22 17260.41 5156.22

FEB 5.47 17727.54 5201.56 9.63 9188.03 2819.21 14.86 16183.81 4839.57

MAR 7.87 15838.38 4769.50 8.03 8995.45 2802.27 14.86 17302.72 5178.15

APR 7.81 16290.99 4901.91 8.70 10911.20 3359.83 13.33 17678.64 5294.76

MAY 7.75 16945.65 5028.66 8.63 13046.14 3957.96 13.91 16844.54 5052.97

JUN 7.69 14997.28 4463.79 9.29 14782.47 4436.37 13.73 17299.75 5187.78

JUL 8.33 13716.18 4124.60 11.89 14635..19 4343.10 11.25 17868.30 5367.60

AUG 9.02 14722.13 4417.12 11.72 15414.19 4571.11 8.82 17971.12 5402.00

SEP 9.77 13942.81 4206.69 11.64 16338.45 4859..31 8.62 20069.12 6029.95

OCT 10.45 10549.65 3210.22 11.49 16825.66 4994.11 8.58 20032.34 6017.70

NOV 10.45 9453.96 2834.79 13.51 16684.29 4953.54 7.48

19647.77

5892.30

DEC 9.70 9513..58 2895.80 14.97 17090.31 5099.74

Though there is no absolute relation between inflation and Stock market indices, inflation has a bearing on the investors in terms of their return being affected due to inflation as explained above and also the risk involved in terms of company’s being wiped out of the market due to continuous .Source:-RBI Bulletin and Economic Times

Literature Review

• Though there are many studies on the relation between stock returns and inflation and hedging inflation risk we have taken some of the important contribution on the studies.• According to Elton et al(1983) the CAPM model fails to capture the impact of inflation required to be taken into account. •Boonekamp(1978) shows that if inflation is uncertain, an investor will generally use the hedging properties of an asset to determine the optional portfolio composition. Manaster (1979) and Sercu (1981)study the relation between real and nominal efficient sets. •They show that a nominally efficient portfolio is equal to a real efficient portfolio plus an additional “hedging portfolio”.

•Bodie (1976) focuses on real asset returns. •He uses a real mean variance frame work to assess the hedging potential of stocks and considers the global minimum variance portfolio consisting of stocks and nominally risk free bonds as well as a portfolio consisting of nominally risk free bonds only. •Bodie (1976) shows that a short position in stocks can be used to hedge against inflation. •Schotman and Schweizer (2000) conclude that the inflation persistence is a fundamental parameter determining the hedging capacity of stocks in the long run. Honevennars et.al (2008)analyze the asset allocation problems of an investor whose liabilities are subject to real interest rate and inflation risk at various time horizons.• They consider a broader set of assets including T-bills, bonds, credits, stocks, commodities, hedge funds and real estate. The hedging capacity of an asset is measured by means of the correlation between nominal asset returns and rate of inflation at various investment horizons.

Literature Review

Literature Review

•All the above studies ignore parameter uncertainty; in particular large uncertainty bounds involved with the impact of inflation on stock returns. • Barberis (2000)in his study has taken into account the uncertainty parameters estimates faced by the investors. •Tomek Katzur and Laura Spierdijk (2010) have also assessed in details the impact of inflation and portfolio selection during inflation.• In our present study we have given the various options available to the investors to hedge against inflation.

•According to Alan Dorsey,Juliana Davydov,and Laura Mistretta (June 2009),The defensive Asset classes (sovereign, Investment grade credits and defensive equities)that perform well during bear markets tend to perform poorly inflationary conditions. •Type of investment strategies adopted were Commodity futures, Cyclically Sensitive sectors such as metals and energy,Private equity, Inflation linked bonds, inflation derivatives. •Charles R Nelson, an economics professor at University of Washigton has studied the impact of price inflation as measured by Consumer Price Index (CPI) during the period 2000 -2006 has concluded that “When CPI inflation is on the rise, stay out of stocks, when the CPI inflation is on the decline by stocks”.

U S Experience

Limitations of the study :- •Due non availability of data on investor’s behavior during the current period of inflation no empirical tests could be conducted

Strategies to protect inflation risk in India

•Investors can prepare for unexpected inflation by adopting one of the two strategies. •They are• a)Hedging the immediate effect • b)Earning a total return that outpaces inflation over time. •As an investor, a substantial portion of the portfolio ought to be in fixed income securities. •Since the inflation erodes the purchasing power, fixed securities are the best option to counterfoil the market volatility. •Even the retirees are advised to keep some amount of their assets as a stock investment.•The interest rate sensitive stocks should be handled with utmost caution during the inflationary period. •It is important to make a distinction between properly anticipated inflation and unanticipated inflation.Farma and Schwert (1977) analyzing the period from 1953-1977, noted that common stock returns were negatively related to the expected component of the inflation rate.


•From strategic point of view, investors may wish to consider an allocation of assets that preserve purchasing power during inflationary periods . •Investors should carefully review their financial circumstances and investment goals before making changes in their portfolio to guard against inflation risk. •Investors should take a total return approach rather than assets based on correlation with CPI (Consumer Price Index).•By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve purchasing power of their cash.


•Inflation Targeting is a new phenomenon adopted by several countries to tackle the inflationary pressures on stock market.•According to Murilo Portugal (2007), Deputy Managing director of the IMF observed in a speech on inflation targeting , the minimum requirements for successful inflation targeting are•1)Central Bank autonomy, Accountability, government support, fiscal discipline •2) Effective instruments for influencing domestic spending and stable financial system. •Rising inflation is associated with falling P/E ratios are not good hedge against in the short run but in the long run they are a perfect hedge against inflation.

•India should consider issue of bonds similar to the one like “Treasury inflation protected Securities”(TIPS) issued by USA. Government of India should consider index linked bonds when the inflation is on the rise. •This can make the government accountable for higher inflation since the cost of borrowing will be linked to inflation if coupon paid is inflation hedged.•Rising inflation will also raise the repayment of inflation linked bonds.• It will help the government to widen the investor base by offering inflation linked bonds at retail level. Inflation linked bonds issued at the retail level will also bring down the inflation.•Sovereign inflation linked bonds can be issued to attract Foreign Funds of foreign exchange reserves of Reserve Bank of India



•The Interest Rate sensitive stocks should be handled with utmost caution during the inflationary period. •Substantial portion of the portfolio ought to be in fixed income securities since the inflation erodes the purchasing power, fixed securities are the best option to counter the market volatility.•Trading in Secondary markets is advisable during inflation as a number of options are available with the Exchange Traded Funds market. Investment in Emerging Market Total Opportunities (ETOP) is another strategy that investments can be made to take advantage of their inherent diversity. •It provides seamless combination of stocks, bonds and convertibles. Investments can be made across several layers of capital structures, across nations and also provides safeguard against inflation in India.

The following Hedging techniques are suggested to over come the inflation risk in Indian financial markets:-

•Leading Inflation Hedges:-•These are assets that tend to perform in advance of inflation becoming visible in the broader economy.• A typically diversified asset portfolio tends to have a greater proportion of leading hedges since most funds are excessively reliant on the equity risk premium to achieve their long term stock returns.

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Hedging techniques

Contemporaneous hedges:- •These include Inflation linked bonds or inflation swaps. Inflation linked bonds are insulated against the raise of inflation by explicitly imbedding a floating rate of inflation into the interest coupon that they pay or by adjusting the capital value of the bonds to reflect the prevailing inflation rate. •Inflation Swap provide investors with price movements in underlying inflation rate. •It works as the exchange of stream of inflation indexed payments/coupon for a stream of nominal interest payments. •These type of hedges are generally over the counter trade products. Countries like Australia, USA, UK, France and Sweden use such products

Hedging techniques

Lagging inflation Hedges:- •These are in assets that offer returns following bouts of inflation. For example as inflation drifts higher, the central banks seek to curb demand by pushing up short term interest rate. •This product was very successful in Australia. Reserve Bank of Australia have been able to maintain average inflation rate of 2.9% over the last 10 years with a corresponding Reserve Bank of Australia cash rate of 5.4%.• As a result the investors are to locking in real rates of return by owning cash. •With addition of margin for active management and with elevated cash rates, absolute return fixed interest looks a vital strategy for achieving real rates of return and a good inflation hedge.

Hedging techniques

Commodity Hedges:- •With the increasing inflation trend the prices of commodities are also bound to go up in the future time. •Hence investing in Commodity Options and Futures are quite advantageous in the inflationary times. •Commodity futures as well as investments in gold, oil are also good and effective inflation hedges because their returns are positively correlated with inflation

Hedging techniques

•In many developed financial markets the existence of inflation linked financial securities provides market based measures of inflation expectation as a measure of hedge against inflation risk.

•Some EME(Emerging Market Economies) like Chile, Israel have been able to develop an inflation linked government bond market.

•The government can develop a break even rate with the following components built in it (i)Expected inflation during the remaining maturity period of the bonds;(ii)inflation risk premium and (iii)liquidity premium.

Conclusion

Conclusion

•Inflation linked bonds are one of the best ways adopted by several countries in the world to over come the inflation risk. Inflation linked bonds are regarded as risk free asset of choice for a long term pool like a Superannuation fund.

•The relevance of an inflation linked security or inflation derivatives is high in a country like India where the inflation enjoys its own crests and troughs displaying a high volatility. It rose from 5.51% in Jan 2008 to 13.73% in June 2010 (Table 1).

•The above Suggestions and techniques to hedge against inflation risk could not be tested empirically as not much of data is available on Indian financial markets as they are innovative thoughts for Indian investors.

•There is scope for further research by conducting primary survey on the investors behavior during the current inflation period and also fiscal management of government of India to contain inflation and also the regulators of the capital market

Scope for further Research

Alan Dorsey,Juliana Davydov,and Laura Mistretta (June 2009), Investment Approaches to inflation risk mitigation.Barberis, N (2000), Investing for the Long run when Returns are predictable. Journal of finance 55, 255-264.Bodie.Z.(1976) Common stocks as a Hedge against inflation, Journal of finance 31, 459-470.Boonekamp, C.F.J. (1978),inflation,Hedging, and the demand for money,American Economic Review,68,821-833.Elton, E.,Gruber,M., and Rentzler. J(1983), The Arbitrage Pricing model and Returns on assets under uncertain inflation. The Journal of finance 38, 525-537.Manaster, S (1979). Real and Nominal Efficient Sets. Journal of finance 34 93-102.Sercu,P(1981), A note on Real and nominal Efficient Sets, Journal of finance 36, 721-737.Schotman. P.C and Schweitzer M (2000). Horizon Sensitivity of inflation Hedge of stocks, Journal of Emphirical finance 7 ,301-315.Hoevenaars,R.P.M.M., Molenaar.R.D.J., Schotman P.C. and Steenkamp,T.B.M.(2008) Strategic Asset allocation with Liabilities: Beyond Stocks and Bonds. Journal of Economics Dynamics and Control 32, 2939-2970.Tomek Katzur and Laura Spierdijk (2010) “Stock Returns and Inflation Risk :Implications for portfolio Selection”.

References and acknowledgments

THANKS

Hedging Inflation Risk in Indian Financial Market

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