Hedging inflation risk in a developing economy: The case of Brazil

Inflation shocks are one of the pitfalls of developing economies and are usually difficult to hedge. This paper examines the optimal strategic asset allocation for a Brazilian investor seeking to hedge inflation risk at different horizons, ranging from one to 30 years. Using a vector-autoregressive specification to model inter-temporal dependency across variables, we measure the inflation hedging properties of domestic and foreign investments and carry out a portfolio optimisation. Our results show that foreign currencies complement traditional assets very efficiently when hedging a portfolio against inflation: around 70% of the portfolio should be dedicated to domestic assets (equities, inflation-linked (IL) bonds and nominal bonds), whereas 30% should be invested in foreign currencies, especially the US dollar and the euro.

► Inflation shocks are usually difficult to hedge in developing countries.
► We examine the optimal strategic asset allocation for a Brazilian investor.
► We measure the inflation hedging properties of domestic and foreign investments.
► Foreign currencies complement traditional assets in hedging inflation.
► Almost one third of the optimal portfolio should be invested in foreign currencies.