A BOOTSTRAP STUDY OF INFLATION HEDGING IN SINGAPORE

Abstract

This study takes a portfolio-based approach to the problem of inflation hedging. It first provides a broad definition of an effective inflation hedging strategy as a portfolio strategy that preserves the real value of an investment portfolio in the presence of inflation. The study specifies two objectives for an inflation hedging strategy: (1) to minimize the loss of value; and (2) to seek positive real return during periods of high inflation. The study then sets out to identify assets that meet these objectives. It classifies assets that meet the first objective as ‘insurance’ inflation hedging assets and assets that meet the second objective as ‘tactical’ inflation hedging assets. Different methods are used to identify the respective types of inflation hedging assets. A meansemicovariance portfolio optimization method, which minimizes negative returns with respect to inflation, is used to find the ‘insurance’ inflation hedging assets. The ‘tactical’ inflation hedging assets are found by isolating the highest periods of inflation and examining the return behaviour of the asset classes in those times. We find that a mixture of different types of local short-term bonds fit the function of the ‘insurance’ inflation hedging asset, while a basket of specific types of energy and agricultural commodities, along with gold, fit the function of the ‘tactical’ inflation hedging asset. Based on our results, we recommend a strategy of dedicating a permanent allocation to the ‘insurance’ inflation hedging assets. The ‘tactical’ inflation hedging assets would be given temporary allocations in anticipation of sustained high inflation periods. We test the strategy on historical data and find that it has the potential to deliver outperforming portfolio returns; the strategy successfully limits the loss and erosion from inflation and preserves the real value of the investment portfolio.