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Do Inflation-Linked Bonds Still Diversify?

  • Marie Briere
  • Ombretta Signori

The diversifying power of inflation-linked (IL) bonds relative to traditional asset classes has changed significantly. In this paper, we study the dynamics of conditional volatilities and correlations for three asset classes, IL bonds, nominal bonds and equities, in the United States and Europe. Using a DCC-MVGARCH for the period 1997–2007, we highlight the change that took place in 2003. Although IL bonds once had definite diversification power, they are now highly correlated with nominal bonds and have reached similar volatility levels. As a result, the two asset classes are practically substitutable. This seems to be due to more stable inflation expectations and to a more liquid IL bond market. Although diversification was a valuable reason for introducing IL bonds before 2003, this is no longer the case. Dynamic portfolio optimization using our estimates of conditional correlations and volatilities clearly demonstrates that the optimal weight of IL bonds in a portfolio decreased sharply in 2003 in favor of nominal bonds and equities.

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File URL: https://dipot.ulb.ac.be/dspace/bitstream/2013/54297/1/RePEc_sol_wpaper_07-029.pdf
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Paper provided by ULB -- Universite Libre de Bruxelles in its series Working Papers CEB with number 07-029.RS.

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Length: 27 p.
Date of creation: 2007
Date of revision:
Publication status: Published by:
Handle: RePEc:sol:wpaper:07-029
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  1. Peter Hoerdahl & Oreste Tristani, 2007. "Inflation risk premia in the term structure of interest rates," BIS Working Papers 228, Bank for International Settlements.
  2. repec:dgr:uvatin:20050044 is not listed on IDEAS
  3. Schwert, G.W., 1988. "Business Cycles, Financial Crises And Stock Volatility," Papers 88-06, Rochester, Business - General.
  4. Engle, Robert F & Sheppard, Kevin K, 2001. "Theoretical and Empirical Properties of Dynamic Conditional Correlation Multivariate GARCH," University of California at San Diego, Economics Working Paper Series qt5s2218dp, Department of Economics, UC San Diego.
  5. Geert Bekaert & Guojun Wu, 1997. "Asymmetric Volatility and Risk in Equity Markets," NBER Working Papers 6022, National Bureau of Economic Research, Inc.
  6. Hunter, Delroy M. & Simon, David P., 2005. "Are TIPS the "real" deal?: A conditional assessment of their role in a nominal portfolio," Journal of Banking & Finance, Elsevier, vol. 29(2), pages 347-368, February.
  7. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Chapters, in: NBER Macroeconomics Annual 1996, Volume 11, pages 155-208 National Bureau of Economic Research, Inc.
  8. Monica Billio & Massimiliano Caporin, 2006. "A generalized Dynamic Conditional Correlation Model for Portfolio Risk Evaluation," Working Papers 2006_53, Department of Economics, University of Venice "Ca' Foscari".
  9. J. Benson Durham, 2006. "An estimate of the inflation risk premium using a three-factor affine term structure model," Finance and Economics Discussion Series 2006-42, Board of Governors of the Federal Reserve System (U.S.).
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