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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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27.1 COMMODITIES AS AN INFLATION HEDGE

According to Greer (1978), one important property of commodity investments, besides diversification, is that commodities can be used as a hedge against inflation. The value of nominally priced assets, such as bonds and stocks, decreases when both expected inflation and unexpected inflation increase. In theory, stocks represent claims against real assets; however, as companies have nominally fixed contracts with suppliers, workers, and capital, stocks do not react directly to an increase in inflation. Stocks represent company ownership and a share in the payout of dividends. Bonds represent a claim on debt repayment, and, in contrast to stocks, the bondholder receives a predefined stream of cash flows. The present value of the future cash flows depends on the size and timing of the cash flow and the assumed interest rate.

In contrast, commodity futures represent the expected spot price in the future. Therefore, commodities are an inflation hedge, as commodity futures prices increase when expected inflation increases. In fact, the increase of commodity prices itself causes inflation, as commodities are part of the basket of goods from which the aggregated inflation of an economy is calculated. Furthermore, because futures represent short-term contracts, they can react to changes in unexpected inflation, as the new information is taken into account when rolling into the next contract. Previous studies show empirically that annual returns of commodity ...

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