Inflation can be a serious problem for investors, especially in countries that routinely experience double-digit inflation. Some investors try to minimize the risk of inflation by using hedges. Hedging is the practice of investing in assets for the purpose of reducing or eliminating particular sources of risk in a portfolio.
Suppose you are planning to retire and will receive a pension that pays you a fixed amount of money every month. If we experience high inflation, your monthly purchasing power will deteriorate. You might want to hedge against the risk of inflation by purchasing an asset whose returns are linked to the rate of inflation. Annuities or bonds whose returns are linked to the Consumer Price Index (CPI) will provide you with returns that increase when inflation increases. These types of assets are considered perfect hedges against inflation.
Although they are not perfect hedges, floating-rate bonds also protect the investor against inflation. Floating-rate bonds are those securities whose interest rates vary according to a rate to which they are tied. For example, the interest rate might be tied to the Prime Rate or the rate of return of US government securities. When inflation rises, the interest on floating rate bonds should also rise, thereby reducing your exposure to the risk of inflation.
These hedging strategies can keep your investment from losing its buying power, as inflation causes prices to rise.
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