Print

Hedging Inflation Risk in a Developing Economy - May 2011

  • Dr. Marie Brière*

    Head of Investor Research Center and associate researcher at Université Libre de Bruxelles
  • Ombretta Signori*

    Fixed Income, Forex and Volatility Strategist

Inflation shocks are one of the pitfalls of developing economies and are usually difficult to hedge. This paper examines the optimal strategic asset allocation for a Brazilian investor seeking to hedge inflation risk at different horizons, ranging from one to 30 years. Using a vectorautoregressive specification to model inter-temporal dependency across variables, we measure the inflation hedging properties of domestic and foreign investments and carry out a portfolio optimisation. Our results show that foreign currencies complement traditional assets very efficiently when hedging a portfolio against inflation: around 70% of the portfolio should be dedicated to domestic assets (equities, inflationlinked (IL) bonds and nominal bonds), whereas 30% should be invested in foreign currencies, especially the US dollar and the euro.

 

Sovereign Wealth and Risk Management - May 2011

  • Zvi Bodie

    Professor of management at Boston University
  • Dr. Marie Brière*

    Head of Investor Research Center and associate researcher at Université Libre de Bruxelles

This paper sets out a new approach to sovereign wealth and risk management, based on the theory of contingent claim analysis (CCA).To manage sovereign risk, it is essential to analyse the sovereign’s balance sheet. The state has to solve an asset-liability management (ALM) problem between its sources of income and its expenditure. The analytical framework for this approach covers all public entities, not only the state budget, and includes implicit guarantees to the private sector. It has a number of essential applications for sovereign wealth management, particularly with respect to sovereign wealth funds (SWFs) and foreign exchange reserves. We present the conceptual framework, tools and data needed to carry out this type of analysis. We then focus on Chile to provide a practical example of sovereign balance sheet estimation and sovereign ALM.

 

Inflation-hedging portfolios in Different Regimes - February 2010

  • Dr. Marie Brière*

    Head of Fixed Income, Forex and Volatility Strategy
  • Ombretta Signori*

    Fixed Income, Forex and Volatility Strategist

The unconventional monetary policies implemented in the wake of the subprime crisis and the recent increase in inflation volatility have revived the debate on medium to long-term resurgence of inflation. This paper presents the optimal strategic asset allocation for investors seeking to hedge inflation risk. Using a vector-autoregressive model, we investigate the optimal choice for an investor with a fixed target real return at different horizons, with shortfall probability constraint. We show that the strategic allocation differs sharply across regimes. In a volatile macroeconomic environment, inflation-linked bonds, equities, commodities and real estate play an essential role. In a stable environment (“Great Moderation”), nominal bonds play the most significant role, with equities and commodities. An ambitious investor in terms of required real return should have a larger weighting in risky assets, especially commodities.

Transmission of financial shocks to the real economy:

the impact of the financial accelerator - January 2010

  • Florian Roger*

    Global Strategist
  • Cathy Dolignon

    Junior Global Strategist

The financial crisis triggered a harsh recession in developed countries in 2008 and 2009. An analysis of the components of GDP growth indicates that the bulk of the decline in economic activity was attributable to capital expenditure. Companies’ investments were more sensitive to their financial situation (i.e. credit conditions and balance sheet position) than was the case in past recessions. This elasticity, known as the financial accelerator, was so great that the majority of economic forecasters were surprised by the magnitude of the resulting economic shock. Conversely, because financial stress has abated significantly since the end of the first quarter of 2009, the financial accelerator should now generate a rebound in investment in 2010. However these movements are not economically benign. They have a degenerative effect and can lead to deflation unless the monetary and fiscal authorities intervene quickly and in force...

The Revenge of Purchasing Power Parity on Carry Trades during Crises - June 2009

  • Dr. Marie Brière

    Head of Fixed Income, Forex and
    Volatility Strategy
  • Bastien Drut*

    Fixed Income, Forex and Volatility
    strategist

Empirical evidence shows that FX fundamental models have produced disappointing results over the past 20 years while carry trade strategies have performed superbly. But the real picture is much more complex.
In fact, the track records of both strategies have varied considerably. This article shows that they have actually alternated between periods of profitability and underperformance. It also shows that when carry trade strategies perform well, fundamental strategies do poorly, and vice versa. Crises appear to play a significant role in the alternation of investment styles on currency markets. In contrast to carry trades, fundamental strategies perform remarkably well in crises. A portfolio that rotates between these two types of strategies, based on a risk aversion indicator such as implied equity volatility, would substantially outperform a pure carry trade strategy.

 

Volatility Exposure for Strategic Asset Allocation - January 2009

  • Dr. Marie Brière

    Head of Fixed Income, Forex and
    Volatility Strategy
  • Alexandre Burgues, CFA*

    Fund Manager
  • Ombretta Signori*

    Fixed Income, Forex and Volatility
    Strategist

Direct exposure to volatility has been made easier, for a wide range of underlyings, by the creation of standardized instruments. The widespread use and increasing liquidity of volatility index futures and variance swaps clearly show that investors are taking a keen interest in volatility. In addition to shortterm trading ideas, some investors now look for a structural exposure to volatility as they consider it either as a well identified asset class or, at the very least, a set of strategies with strong diversifying potential for their portfolios.
The scope of this paper is therefore to construct an analytical framework useful for investors willing to assess the benefits of a long-term investment in volatility…

 

Crisis-Robust Bond Portfolios - April 2008

  • Dr. Marie Brière*

    Head of Fixed Income, Forex and
    Volatility Strategy
  • Prof. Ariane Szafarz

    Director of the Centre Emile Bernheim
    Solvay Business School Université
    Libre de Bruxelles

A financial crisis is typically associated with a rise in the volatility of most assets. Moreover, if the crisis is “contagious”, things become even worse for investors because correlations among asset returns also increase and diversification becomes less efficient than during quiet periods. As most identified financial crises have been positively tested for contagion (Loretan and English (2000), Hartmann et al. (2001), Bekaert et al. (2005)), this problem warrants close attention.
To reduce investors’ excessive exposure to crisis effects (Chow et al. (1999)), this study builds “crisis-robust” portfolios, i.e. those exhibiting the least change in volatility during crises. Such portfolios enable investors to minimize as much as possible the perverse effects of volatility caused by a crisis…

 

*Photos: Thierry Ledoux.