HEDGING AGAINST INFLATION
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Inflation can be a serious problem for investors, especially in
countries that routinely experience double-digit inflation. Some investors try
to minimize the risk of inflation by using hedges.
Hedging is the practice of
investing in assets for the purpose of reducing or eliminating particular
sources of risk in a portfolio.
Suppose you are planning to retire and will receive a pension
that pays you a fixed amount of money every month. If we experience high
inflation, your monthly purchasing power will deteriorate. You might want to
hedge against the risk of inflation by purchasing an asset whose returns are
linked to the rate of inflation. Annuities or bonds whose returns are linked to
the Consumer Price Index (CPI) will provide you with returns that increase when
inflation increases. These types of assets are considered perfect hedges against
Although they are not perfect hedges, floating-rate bonds also
protect the investor against inflation.
Floating-rate bonds are those
securities whose interest rates vary according to a rate to which they are tied.
For example, the interest rate might be tied to the Prime Rate
or the rate of return of US Government securities. When inflation rises, the
interest on floating rate bonds should also rise, thereby reducing your exposure
to the risk of inflation.
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