Real duration and inflation duration: A cross country perspective on a multidimensional hedging strategy

Abstract

In this study we consider two different duration measures: (i) real duration, which is a measure of a financial instrument (asset or liability) value sensitivity with respect to changes in the real interest rate, and (ii) expected-inflation duration, which is a measure of the instrument value elasticity with respect to changes in the expected rate of general price inflation. These two measures arise because the nominal interest rate is divisible into a real rate and the expected-inflation rate. Thus, when inflation is present, a duration measure depends on the source of the change in the interest rate. We empirically examine cross-country differences and show that in low (negative) nominal rate environments (France and Germany), nominal rates are less responsive to changes in inflation expectations that in a high nominal rate environment (Italy). We show that under-protection of cash flows against inflation may significantly lower the asset value with a sizeable expected-inflation duration. On the other hand, assets with an indexation scheme that over protects against inflation, will be significantly more expensive with nontrivial and negative elasticity with respect to the inflation rate. Finally, we demonstrate that the real and expected-inflation durtion can be utilized to simultaneously hedge the net worth of a firm against adverseimpacts of changes in the real interest rate and changes in the expected-inflation rate.