What is inflation risk and how do you mitigate it?
Inflation is a growing concern worldwide. Learn what inflation risk is and how inflation affects your trading. Plus, discover ways to hedge against it and how to trade it with world’s No.1 CFD provider.1
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What is inflation?
Inflation is the lessening of money’s purchasing power in an economy. Through inflation, the cost of consumer items and services rises – meaning your money is worth less than it used to be. This weakens a currency as each franc buys you fewer things than before the rise in inflation.
Inflation is usually measured within a country – the term for this is ‘headline inflation’. Two acronyms are associated with headline inflation: CPI (Consumer Price Index) and RPI (Retail Price Index). CPI refers to the current price of consumable goods in shops, while RPI is slightly broader and also refers to other costs of living you won’t find in stores, such as property prices, mortgage interest rates and more.
CPI and RPI are by far the most commonly used terms when speaking about headline inflation, although other inflationary indices exist.
Because inflation makes money worth less, it’s problematic for any non-inflation linked investment as it lowers the real value (ie the purchasing power) of those returns.
What is inflation risk?
Inflation risk is the possibility that unexpected inflation will significantly erode the real value of the returns you’d get from an investment.
With higher inflation, you may still get future income from an investment, but what that money can actually buy is diminished because the cost of living has risen – even if the monetary amount hasn’t changed. This is especially worrying for investors in fixed-income assets like bonds, where coupon amounts remain consistent but their real value declines.
This is a compelling reason why many choose to trade rather than invest when inflation is a concern.
However, trading on inflation has its risks, too – particularly as inflation can provide a volatile environment where it’s possible to make profits or losses very quickly and unpredictably.
When trading inflation with us, you’ll do so via CFDs – a type of financial instrument called a derivative, where you won’t take ownership of shares or any underlying asset, but will instead speculate on inflation itself. If your predictions are correct, you’ll make a profit and if incorrect, you’ll make a loss.
CFD trades are leveraged. That means you only have to put up an amount (called margin) which is a fraction of the total cost of your position’s size. So, for instance, with a 5% margin, you’d put down CHF50 to open a trade worth CHF1000. This means that you can take a position on larger volumes, which increases your potential gain, but also your potential loss. This is because, with leverage, both profits and losses are calculated on the total position size, not the margin amount.
Inflation risk: an example
Let’s say you buy a bond with a coupon rate of 3%, which is a normal, nominal amount when you invest in the bond. However, if the inflation rate is 2% at the time, your purchasing power is only really increasing by 1%. This is your real return.
In its most basic form, the formula for calculating your real return is:
Real return = nominal return − inflation
Because bonds are fixed-income assets, your coupon rate won’t change with time, even if the inflation rate does. So, if the inflation rate climbs above 2%, it’ll erode the value of your bond even further. In a worst-case scenario, your real returns could even become negative. Say, for instance, the nominal return is 3% but inflation is sitting at 5%:
3% nominal − 5% inflation = −2% real return
Here, your investment is actually losing you money, even though your nominal return (3%) hasn’t changed.
What is an inflation risk premium?
An inflation risk premium is the amount a lender will pay to the investor to compensate them for taking on inflation risk. This premium increases the returns an investor might see on fixed-income assets in a time of inflation hikes, making them more attractive.
Inflation risk vs interest rate risk
Inflation risk and interest rate risk are sometimes confused, as they’re closely related in the bond market.
- Inflation risk is the chance that your return from an investment (eg bond coupons) can lose value in real terms due to a rapid inflation rate
- Interest rate risk is the chance that the value of an asset (like bonds) can decrease due to increasing interest rates and a hawkish environment
Rises in inflation are often followed by increases in interest rates. That’s because central banks, like the US Federal Reserve Bank for example, often hike interest rates to discourage cash-strapped consumers from spending too much on credit when inflation makes prices increase.
Due to this, bond prices and interest rates are inversely related – when interest rates rise, bond prices fall, and vice versa.
If you decided to sell a bond on the secondary market at a time when the rate of interest had risen significantly, you’d receive a price lower than the bond’s face value if its coupon is lower than the current interest rate.
On the other hand, an increase in the inflation rate would mean that each coupon payment made by the bond would be increasingly less valuable to a bond holder. That’s because the bond’s real interest rate would have been lessened.
How to hedge against inflation risk
- Traditionally, gold is viewed as a hedge against inflation and tends to do well during times of aggressive hikes
- The fact that many view gold as such will, more often than not, boost its prices during any period of uncertainty, making it a valuable hedge
- With us you can trade on gold as a commodity, as well as on gold-exposed companies such as miners. This means you won’t take possession of any physical gold but can instead make a profit or a loss by predicting the movement of the underlying gold market you’re trading on
Treasury Inflation Protected Securities (TIPS)
- If the inflation you want to trade is global in nature, you can also trade on TIPs, securities issued by the United States Treasury
- TIPS are benchmarked against the US Consumer Price Index (CPI), so when the cost of living rises due to inflation, so does the value of a TIPS bond
- This means these, too, can provide protection against rising inflation
UK index-linked gilts
- The British equivalent of TIPs is UK index-linked gilts: a bond issued by the UK government designed to combat inflation
- Index-linked gilts are supposed to have coupon payment amounts that rise when inflation rises, ensuring that an investor’s final settlement repayment matches the accrued inflation amount over the years that bond has been held
- This means that investments generally do better in a higher inflation environment, so they can be used to hedge against other asset classes more vulnerable to inflation
How to hedge inflation with us
With us, you can use trading to hedge against inflation. Follow these steps to take a position:
- Research your preferred market
- Open a live account or practise on a demo
- Take steps to manage your risk
- Select ‘place deal’ and monitor your position
Trading for inflation risk
When trading, you won’t own any shares or ETFs outright, but will instead speculate on the price of stocks, bonds, commodities or any other market you think will do well against inflation.
You can do this using a CFD trading account.
As a trader, you’ll take a position on the performance of the underlying market during inflation – such as government bonds, futures, gold and more – going long if you think the market’s price will rise and going short if you think it’ll fall. You’ll make a profit if you predict this correctly, and a loss if you don’t.
Inflation risk summed up
- Inflation is the decreasing of money’s purchasing power
- Inflation risk is the chance that inflation will lessen the purchasing power of your investments over time – making a compelling case for trading over investing
- With us, you can trade on inflation using CFDs
- You can also hedge against inflation with us by trading on a number of other asset classes such as gold or bonds
1 Based on revenue excluding FX (published financial statements, October 2021)
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