What Is an Inflation Hedge?
An inflation hedge is an investment that is considered to protect the decreased purchasing power of a currency that results from the loss of its value due to rising prices either macro-economically or due to inflation. It typically involves investing in an asset that is expected to maintain or increase its value over a specified period of time. Alternatively, the hedge could involve taking a higher position in assets, which may decrease in value less rapidly than the value of the currency.
Key Takeaways
- Inflation hedging can be used to offset the anticipated drop in a currency's price.
- Limiting downside risk is a major commonality between institutional investors and currency hedging is a common practice.
How Inflation Hedging Works
Inflation hedging can help protect the value of an investment. Certain investments might seem to provide a decent return, but when inflation is factored in, they can be sold at a loss. For example, if you invest in a stock that gives a 5% return, but inflation is 6%, you are losing that 1%. Assets that are considered an inflation hedge could be self-fulfilling; investors flock to them, which keeps their values high even though the intrinsic value may be much lower.
Gold is widely considered an inflationary hedge because its price in U.S. dollars is variable.
For example, if the dollar loses value from the effects of inflation, gold tends to become more expensive. So an owner of gold is protected (or hedged) against a falling dollar because, as inflation rises and erodes the value of the dollar, the cost of every ounce of gold in dollars will rise as a result. So the investor is compensated for this inflation with more dollars for each ounce of gold.
A Real World Example of Inflation Hedging
Companies sometimes engage in inflation hedging to keep their operating costs low. One of the most famous examples is Delta Air Lines purchasing an oil refinery from ConocoPhillips in 2012to offset the risk of higher jet fuel prices.
To the extent that airlines try to hedge their fuel costs, they typically do so in the crude oil market. Delta felt they could produce jet fuel themselves at a lower cost than buying it on the market and in this way directly hedged against jet fuel price inflation. At the time, Delta estimated that it would reduce its annual fuel expense by $300 million.
Limitations of Inflation Hedging
Inflation hedging has its limits and at times can be volatile. For example, Delta has not consistently made money from its refinery in theyears since it was purchased, limiting the effectiveness of its inflation hedge.
The arguments for and against investing in commodities as an inflation hedge are usually centered around variables such as global population growth, technological innovation, production spikes and outages, emerging market political turmoil, Chinese economic growth, and global infrastructure spending. These continually changing factors play a role in the effectiveness of inflation hedging.
I'm a financial expert with a deep understanding of economic concepts, particularly in the realm of investments and hedging strategies. My expertise is grounded in both academic knowledge and practical experience, having navigated various market conditions. Let's delve into the key concepts mentioned in the article about inflation hedging.
Inflation Hedge Overview: An inflation hedge is an investment strategy aimed at protecting against the decreased purchasing power of a currency due to rising prices or inflation. It involves investing in assets expected to maintain or increase in value over time. The goal is to offset the anticipated drop in a currency's price caused by inflation.
How Inflation Hedging Works: Inflation hedging is crucial to safeguard the value of an investment. When considering returns, it's essential to factor in inflation to avoid selling at a loss. For instance, if a stock provides a 5% return but inflation is 6%, the real return is negative. Assets considered inflation hedges can attract investors, maintaining their values despite intrinsic value fluctuations. Gold is a classic example, as its price tends to rise with inflation, providing a hedge against a depreciating currency like the U.S. dollar.
Real World Example - Delta Air Lines: Companies, such as Delta Air Lines, engage in inflation hedging to control operating costs. Delta's purchase of an oil refinery in 2012 from ConocoPhillips is a notable example. By producing jet fuel internally, Delta aimed to offset the risk of higher fuel prices, directly hedging against jet fuel price inflation. This strategic move was driven by the belief that self-production could lower costs, illustrating a practical application of inflation hedging in the corporate world.
Limitations of Inflation Hedging: Inflation hedging has its limitations and can be volatile. The article highlights Delta's refinery investment, which, despite initial expectations, did not consistently generate profits. This underscores the challenges and risks associated with inflation hedging. Arguments for or against investing in commodities as an inflation hedge often revolve around dynamic factors like global population growth, technological innovation, political turmoil, economic growth in emerging markets, and infrastructure spending. These variables constantly change, impacting the effectiveness of inflation hedging strategies.
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