Do diversified portfolios effectively hedge inflation and volatility risks?

Abstract

This paper investigates the effectiveness of a set of assets and asset allocation strategies in hedging inflation risk, market volatility risk and their joint risk. Using monthly returns data between 1980 and 2024 for 15 different assets – including Stock Indexes, Bonds, Commodities, Real Estate Indexes, and currency pairs - I build naively or through optimization 18 portfolios, constrained to transaction costs and no short-selling. Inflation Rate is based on Consumer Price Index and estimates of volatility on the monthly returns of the MSCI World Index. The methodology extends the Modern Portfolio Theory by introducing a three-dimensional efficient surface that incorporates expected return, and the sensitivities to inflation and volatility, and then comparing it with traditional allocation strategies. Hedging effectiveness is assessed through linear regressions using models with expected and unexpected components of inflation and volatility, lagged realized values of the two variables, and conditional volatility from a GARCH (1,1) model. Further robustness tests are made by including standard factor models such as FF3, Carhart and FF5. The study is validated by the orthogonality and the ambiguous Granger-causality of the two main sources of risk studied in this paper. I find that none of the assets or portfolios is an effective hedge of inflation and its components. I also find that individual assets are unable to perfectly hedge volatility and just a few portfolios can do so, but none does so in a consistent statistically significant manner.

Date of Award	25 Jun 2025
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Eva Schliephake (Supervisor)