Inflation Risk Hedging Strategy for Equities using Commodity Futures

Abstract

The paper attempts to provide a possible hedging strategy against reduction in equity valuations due to inflation, using commodity futures. Commodity futures for four commodities namely pepper, steel, wheat and mustard seed are used along with sector equity indices of National Stock Exchange (NSE), India to determine plausible benefits of hedging equity risks with commodity futures. The effectiveness of the hedged portfolios is tested using standard statistical methods. The risk and return of a portfolio hedged with commodity future is compared with an equity only portfolio. The work thus provides an alternative hedging strategy against inflation for investors with primary investments in equities. Inflation has often been described as a necessary 'evil' counterpart of economic growth, as it helps in fuelling development in one hand, while eating into the profits and margins of companies on the other. The overall impact of inflation on a company's operations has been studied by academicians, stating how a positive impact on revenue is offset by increase in operating costs (1) - (5). Moreover, a rise in inflation has been shown to adversely affect a company's equity valuation in the short term, thereby increasing the downside risk for investor (6). Commodity prices have also been shown to be a leading indicator of inflation (7). In recent times, due to complex inter-linkages, inflation may be affected by numerous factors. Spike in crude prices in oil markets translates into price rise across sectors in India, depending on government policies. Grain storage issues and rainfall also strongly affect the food inflation. But, the strong relation between commodity prices and inflation cannot be ignored. Moreover, the development of commodity derivatives market in India offers an important investment opportunity. In an inflationary environment, the rise in price of commodities may be used to offset the fall in short-term equity valuations. Hence, commodities and its derivatives may provide a possible hedge against loss in value of assets due to inflation. Such a hedged portfolio would be useful for investors with high equity investments in an inflationary economy. Possibility and effectiveness of including commodities in a portfolio has been examined in this paper. The paper creates a portfolio of equities and commodity derivatives, and tests the efficacy of such a portfolio against loss in value using statistical analysis.