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Inflation-Protecting Asset Allocation: A Downside Risk Analysis ERES Conference, 5 th July 2013

Inflation-Protecting Asset Allocation: A Downside Risk Analysis ERES Conference, 5 th July 2013. Tim Koniarski, Steffen Sebastian. Motivation. The study is motivated by two facts:

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Inflation-Protecting Asset Allocation: A Downside Risk Analysis ERES Conference, 5 th July 2013

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  1. Inflation-Protecting Asset Allocation: A Downside Risk AnalysisERES Conference, 5th July 2013 Tim Koniarski, Steffen Sebastian

  2. Motivation The study is motivated by two facts: • Previous studies only focus on correlations between asset returns and the inflation rate to investigate the inflation-protecting abilities of assets analysed. • In the asset allocation context the variance is used as risk measure to determine optimal inflation-protecting portfolios.

  3. Contribution • We analyse horizon-dependent inflation-hedging abilities of the assets (cash, bonds, stocks and direct commercial real estate) using lower partial moments and compare the results to VAR-implied correlations. • Account for asymmetric returns by bootstrapping multi-period returns. • Augmented by transaction costs. • Determine optimal inflation-protecting asset allocations within 2nd order LPM (CLPM) framework. • Variation of target returns.

  4. VAR approach • VAR model includes asset returns and additional state variables (dividend-price ratio, term spread, cap rate and inflation) • VAR-implied variance: • Multi-period returns are bootstrapped according to Benkwitz et al. (2001).

  5. Lower partial moments • Downside risk measure: Lower partial moments (LPM) • The LPM of order n is estimated by where is the target rate and is the return of asset i with T observations. • Focus on • LPM ofordern = 0, theshortfallprobability • LPM ofordern = 1, theexpectedshortfall • LPM ofordern = 2, semivariance

  6. Co-lower partial moments • Portfolio context: Takingintoaccountco-movementsbetweenassets • According to Estrada (2008), a co-lower partial momentbetweenassetiandjisdefinedas • The resultingsymmetricsemivariancematrixisusedfortheportfoliooptimizationproblem.

  7. Data set • Quarterly US data from 1978:Q1 to 2010:Q4. • Direct real estate returns are desmoothed appraisal-based returns with the method proposed by Geltner (1993).

  8. VAR parameter estimates

  9. Correlations between asset returns and inflation

  10. Inflation-protecting qualities of assets

  11. Minimum semivariance portfolios, target 0%

  12. Minimum semivariance portfolios, target 1+2%

  13. Conclusion • Considering correlations to investigate inflation-hedging potential of assets can imply false conclusions. • Inflation-protecting abilities of assets change substantially over the investment horizon. • Cash performs best in the short run, but worst in the long run. • Real estate protects investors best against inflation for longer investment periods. • These changes also affect optimal inflation-protecting asset allocations. • Investors requiring a higher real return allocate more volatile assets on a medium and long-term basis.

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