Introduction to Asset Allocation

Can someone please explain me how an investor can isolate inflation risk by going long on Tresuries and shorting inflation linked bonds

It is mentioned in Schweser notes book 2 reading no 16 and los f

going long on treasuries - interest rate goes up, treasuries value goes down, you lose.

you compensate by shorting inflation linked bonds - interest rate goes up, you are shorting the inflation linked bonds, the bond value goes down, you gain.

so you isolate the inflation risk.

Can u please elaborate?

Like I dont understand…isolating the inflation risk means getting exposure to inflation risk?

So from what u have explained it seems you are neutralizing the inflation risk that it won’t matter to you even if inflation goes up or down, so you have kind of zero exposure to inflation risk.

I would really appreciate if anybody else can help on this.

That’s actully a good question…

Depending if you want long or short exposure to inflation would dictate how the trade is structured. Remember, when we talk about how interest rate movements affect bond prices, we are talking about nonimal interest rates, which is the real rate + inflation. With TIPS, your only exposing yourself to the Real Rate. If you go long treasuries, you have exposure to both Real Rates and Inflation, and by entering a short TIPS, you have exposure to only Real Rate. The Long/Short would make you delta neutral on Real Rates, leaving you with only exposure to Inflation. Hope this helps.

if you short a TIPS, then you have the opposite effect of a long TIPS, meaning you would then have exposure to nflation risk, and not real rate. Right?

Go long Treasury = Long Exposure to Rates (nominal) Go Short TIPS = Short Exposure to Rates (Real) Remains = Long Inflation Not sure the context of the question but that what I think they are getting at.

1 Like