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Excerpt from Variance Minimization and the Theory of Inflation Hedging
The term hedging against inflation as used in this paper, means reducing the specific kind of risk which stems from uncertainty about the future level of the prices of consumption goods. In other words, we use the term in exactly the same way one would use it to describe the forward purchase or sale of commodities or foreign currencies for the purpose of eliminating the risk of unanticipated changes in spot prices or exchange rates. Just as futures contracts for commodities and foreign currencies are perfect hedges against unantici; pated fluctuations in spot prices and exchange rates, so futures contracts for the specific basket of consumer goods used to define the real value of money the purchasing power of money) would be a perfect hedge against inflation risk.
Recently there has been a revival in this country of the proposal to link deferred payments to some index of the cost - of - living like the cpi.3 Effectively an index - linked bond is equivalent to an ordinary nominal bond plus a futures contract on the cpi. For example.
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