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| Risk & Reward |
Inflated Expectations
John Ferry
09/01/2005
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Another tool for hedging inflation is
a structured note with an inflation-linked payoff. For example, an investor can
purchase an investment tied to the performance of the Dow Jones AIG commodity
index, in which the initial investment principal is guaranteed (so the
instrument would have very little risk). Index-linked products of this nature
typically offer the investor some percentage of any positive move in the index.
“We find that to be a particularly compelling approach at this stage because
commodities and their associated indexes have had some big moves,” explains John
Skjervem, the Chicago-based chief investment officer for Northern Trust’s
personal financial services division. Products such as these typically have a
five-year tenor.
Another promising source of hedging products is the
emerging inflation derivatives market. These are very new instruments—most are
only a few years old—and are now traded exclusively by sophisticated financial
institutions. Oberhoffer expects the market to develop to the point where
private investors can access it. But for now, the market for swaps on TIPS—a
fairly straightforward derivative that allows investors to manage their interest
rate exposures by trading fixed payments for floating, or vice versa—is still
five years behind the regular TIPS market in terms of liquidity. “As these
things become more liquid, I would think they should become a viable option for
a high-net-worth investor looking to protect against inflation,” Oberhoffer
adds.
If so, a private investor will someday be able to arrange a transaction
in which he overlays a floating rate money market investment with an inflation
swap that lets him pay the interest he receives from the money market and
receive the total return on a TIPS bond for a certain period of time. The end
result is a “synthetic” and less expensive investment in TIPS. Also, because a
transaction like this needs to be only partially collateralized, it allows
investors to leverage their principal, adding further flexibility, Oberhoffer
notes.
Most believe inflation remains tame for the present. But the growing
pressures in the housing and energy markets, along with the falling dollar and
the fact that the Fed is hamstrung from raising rates too much by fears it will
harm the economy, raise legitimate concerns about its reappearance. Private
investors who worry about its caustic effects on a portfolio now have an array
of tools to manage it, while earning a respectable return.
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