Inflation Hedging in India

Abstract

Inflation in India has been moderately high and volatile. In this paper we provide an estimate of the conditional mean and variance of CPI and WPI inflation rates with the help of a GARCH (1, 1) model. Under an environment of inflation uncertainty, rational risk-averse investors demand an inflation risk premium, defined as the difference between the expected real return on a nominal bond and the expected riskless real interest rate (often represented by the expected real return on an inflation-indexed bond). The sign of the inflation risk premium is a function of the inflation-hedging capability of alternative securities, such as gold, silver and stocks. Our estimated empirical models consistently find gold and silver to be effective hedges against expected WPI inflation rate, the predominant measure of Indian inflation. As for Indian equities, we find a strong negative correlation between the nominal returns and the conditional standard deviation of WPI inflation, providing empirical support of a positive inflation risk premium for Indian interest rates.