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Hedging against Price Index Inflation with Futures Contracts

✍ Scribed by Anthony F. Herbst

Publisher
John Wiley and Sons
Year
1985
Tongue
English
Weight
758 KB
Volume
5
Category
Article
ISSN
0270-7314

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✦ Synopsis

lthough it is generally believed that futures contracts offer a means for pro-A tection against price level inflation, there is little published research to guide one in selecting a set of futures contracts to hedge against inflation as measured by a specific price index. The purpose of this research is to determine if risks associated with specific price indices, such as the Consumer Price Index or Wholesale Price Index, can be effectively hedged with a parsimonious set of objectively selected futures contracts. Objective selection is in principle possible through the use of principal components analysis in combination with other multivariate techniques. The practical significance of this research is to determine whether risks stemming from cost-of-living adjustments to wages, salaries, pension liabilities, rental contracts, etc., might be hedged with a specific set of commodity futures whose historical composite performance suggests that their price changes will continue to correlate highly with changes in the particular price index creating the risk.

The term "inflation hedge" may be defined to be an investment medium whose price appreciates at a rate substantially equal to the hedger's relevant rate of inflation.

The purpose of this research is to examine relationships between consumer price index changes and the aggregate of futures market price changes. The objective is to determine if firms facing cost-of-living-adjustment (COLA) contract risks can hedge them using a weighted average of a small number of futures contracts, with the weights determined so as to optimize the hedging effectiveness; i.e., maximize the correlation between the futures prices and the price index. Since there is This research was funded in part by a grant from the Center for the Study of Futures Markers, Columbia University.

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The authors are grateful to Bernard Dumas and the anonymous referees for helpful comments and suggestions. Any remaining errors are the authors' responsibility. 'Important studies advancing methods accepted by practitioners include