Hedging against inflation across markets: Economic Times 9th September 2009

TODAY, a major concern for everyone is inflation and while the WPI remains in the negative, the CPI is a positive double-digit number. Inflation hedging becomes important considering that one cannot trade any inflation index in the futures market. The alternative is to look for proxies, which are positively correlated with inflation that can be used for hedging purposes.To begin with WPI and CPI are correlated at 0.96, which means that high levels of CPI are associated with high values of WPI. Hence, only the WPI has been considered for preservation of clarity. Some interesting results emerge when these coefficients are calculated on an average monthly basis for the period 2004 to 2009 (up to July) i.e. 67 months.Gold is the best inflation hedge which can be used to guard against inflation followed by the euro. This really means that taking a long position in gold or euro when we expect inflation to increase would make sense as we can sell the same and take cover for inflation. Silver is the third best option. The fact that the euro serves the purpose better indicates that RBI should get set to introduce forex futures in euro as well, especially as the dollar contracts have been quite successful on the NSE. This way the lacunae in the commodity market can be bridged by the forex derivative market.As for the Gsec market, it is not highly correlated with the WPI numbers . It has been held that the WPI number matters for the bond market which is sensitive to the information. The low correlation between the benchmark 10-year bond yield and WPI indicates that on an average long-term basis this relation is not really strong.Surprisingly, the stock market is also not linked strongly with inflation with a correlation of just over 50%. The stock market is guided by other factors and inflation is just one of them. The same holds for crude which, with a weight of 14% in the WPI, could provide a partial hedge with a 51% correlation. The surprise package is guarseed which has a significant though low correlation with inflation, even though it is not a part of the WPI.The rupee-dollar move differently with other markets. Depreciation in the rupee has an inverse relation with both the stock market and crude oil price. While the stock market can be expected to decline with the rupee weakening, typically one would have expected falling crude prices to strengthen the dollar, which has not happened, meaning thereby that the crude oil bill is not significant in affecting the dollar rate and is influenced by a combination of capital receipts as well as RBI action.Commodities like gold, silver and guar have a median positive correlation with Nifty, which means that there are limited opportunities for arbitrage across these segments. The Gsec market, however, becomes negatively related with bullion, indicating substitution and hence offering scope for independent decisions that can be taken by banks and insurance companies in the commodity space.Therefore, there are several windows open for trading and hedging across markets which will improve overall efficiency. And more importantly , inflation cover can be achieved through various options.