Viewpoint
May 2013
Your Global Investment Authority
Vineer Bhansali, Ph.D.
Dr. Bhansali is a managing director and
portfolio manager in the Newport Beach
office. He currently oversees PIMCO's
quantitative investment portfolios. From
2000, he also headed PIMCO's firmwide
analytics department. Prior to joining
PIMCO in 2000, he was a proprietary trader
in the fixed-income trading group at Credit
Suisse First Boston and in the fixed income
arbitrage group at Salomon Brothers in
New York. Previously, he was head of the
exotic and hybrid options trading desk at
Citibank in New York. He is the author of
numerous scientific and financial papers
and of the books "Bond Portfolio Investing
and Risk Management," "Pricing and
Managing Exotic and Hybrid Options," and
"Fixed Income Finance: A Quantitative
Approach." He currently serves as an
associate editor for the International Journal
of Theoretical and Applied Finance. He has
23 years of investment experience and
holds a Ph.D. in theoretical particle physics
from Harvard University. He has a master's
degree in physics and an undergraduate
degree from the California Institute of
Technology.
Inflation Tail Risk Hedging
A version of this paper will appear in the Winter 2014 edition of The Journal of Portfolio
Management.
In the aftermath of the 2008 crisis, the phrase “tail risk
hedging” has entered the vernacular of financial market
participants with a speed and intensity unmatched by any
other market concept in recent memory.
However, this concept so far has largely been limited to the hedging of risks
related to rapid declines in equity-related markets. Policymakers are well aware
of these equity market risks, which from a macro perspective are associated with
a deflationary fat tail, and have flooded the markets with unprecedented
amounts of liquidity – via low interest rates, an increasing quantity of money and
outright asset purchases. These extreme measures, by most metrics, have
resulted in a historically unprecedented set of market conditions and raise the
question of whether there are other risk factors “under our noses” whose tail
risks now need to be anticipated and proactively managed. This paper reviews
what we know about observed and expected inflation, and then discusses
practical techniques for hedging inflation tail risks.
Indeed, both theoretically and empirically there are reasons to believe that in
addition to the equity risk factor, the duration risk factor (or sensitivity to interest
rates) is the second key variable that drives investment risks over long horizons.
This is economically sensible, since growth largely drives the returns of equity
markets, and inflation largely determines the returns to credit-risk-free fixed
income instruments. Clearly equity market risk is more volatile and has
historically been higher frequency than inflation risk, and hedging techniques
have to be adapted appropriately to these inherent differences. But we believe
that while the last five years might have made it possible for us to ignore the tail
risks from the rise in interest rates (given the tailwind of central bank liquidity
injections of various sorts, low realized and expected inflation and low interest
rates), continuing with this assumption might no longer be a very safe approach.
First, since global central banks around the world are
injecting an unprecedented amount of liquidity into the
financial markets to boost asset prices and raise inflation
expectations, expecting inflation to remain subdued for a
very long period of time does not seem to be an evenly
biased bet. Other than the direct influence of a ballooning
money supply, the demand for food and energy globally,
not the least from newly emergent nations, could result in
consequential inflation spikes not unlike those witnessed
in the early 1970s. The direct purchase of mortgages by
the Federal Reserve has resulted in a lowering of the
mortgage interest cost that plays an important role in the
computation of an inflation index such as the U.S.
Consumer Price Index (CPI).1 A rise in these mortgage rates
could result in a substantial percentage rise in the CPI as
the cost of servicing the loans flows indirectly into the
inflation indexes. Indeed, in today’s low-inflation
environment these events seem much too remote and
unlikely, both in terms of probabilities and potential
severities, but so did the possibility of a rapid credit market
widening prior to the 2008 crisis.
Second, rising inflation can affect not only fixed income
assets, which occurs directly since yields and prices move
inversely to each other, but also the prospective returns of
all risky assets. This occurs conceptually because most risky
assets derive a significant part of their value from the
discounting of future cash flows, and the discount factor
used for the present value computation is driven mostly by
the path of policy rates, inflation expectations and the
inflation risk premium.
Finally, even without inflation actually rising, the rise of
inflation uncertainty can result in rising inflation risk
premiums (there is plenty of empirical evidence and
theoretical basis to justify that high levels of inflation will
be correlated to high inflation volatility, which is the
1
In this paper we will not address the question of whether the
measurement of the CPI shows a persistent tendency for downward
bias. For an interesting discussion please see Robert J. Gordon and
Todd vanGoethem, 2007.
primary driver of inflation risk premia) and thus result in
adverse performance of inflation-sensitive assets. This
variability, while currently low, can amplify the impact of
rising inflation and inflation expectations as and when they
occur.
While the impact of rising inflation on liabilities is well
understood and managed, the impact on the pricing of
asset portfolios is equally relevant for inflation tail risk
management. For the purpose of this paper, we do not
fixate on predicting which part of portfolios inflation is
going to have a larger impact on. We believe that the tail
risks on the total value of the portfolio assets and
liabilities, and the techniques described here, can be
practically useful for both aspects.
Hedging “at-the-money” inflation versus inflation
tails
Before diving into the details of inflation tail hedging, we
would like to clarify some issues that become important
for implementation.
First, when one thinks of inflation hedging, it is important
to distinguish between two kinds of inflation risks: small,
expected deviations from current inflation and large,
unanticipated inflation spikes. Since asset markets discount
expected inflation fairly efficiently, an approach that uses
asset allocation techniques efficiently is best suited for
relatively small, expected deviations from current inflation.
We discuss how to find and scale allocation to such assets
below.
Second, for hedging purposes it is not sufficient to find
assets that have exhibited anecdotal contemporaneous
positive correlations with inflation in particular episodes,
since many of these correlation relationships are horizon-
and period-sensitive. For the hedge to be robust, it is
critically important that the cumulative returns over a
period of time on the hedging instruments are positively
correlated to the factors that drive the cumulative increase
in inflation. Since most assets exhibit much higher volatility
than the inflation rate over short periods of time, the
efficacy of short-term correlations (or betas) for hedging
MAY 2013 | VIEWPOINT 2
becomes questionable if one relies too heavily on simplistic baskets of inflation-sensitive equities, are other examples
anecdotal and episodic correlation analysis. that can be utilized to create more robust portfolio mixes
against moderate persistent rises in inflation (see Johnson,
Third, we should be prepared for the same assets to
2013). Of course, for practical implementation, we would
exhibit different hedging behavior as a function of the
need to estimate the potential transaction costs of
time horizon. For instance, there is a large amount of
switching from traditional assets to these alternatives, and
academic and practitioner literature that discusses the
liquidity concerns might prohibit the use of many of the
weak hedging nature of equities against inflation over
less liquid categories.
short horizons but a more reliable hedging relationship
over a longer horizon. Rather than thinking of this change In contrast, and importantly so, when we talk about
of inflation hedging potency as a detractor, we should inflation “spikes” or “tails,” the dynamic asset allocation
think of this horizon-dependent variability as an essential approach to managing inflation needs to be
ingredient in the construction of actively managed complemented with more convex inflation-hedging
portfolios that are robust over a variety of hedging strategies. There are three main reasons for this. First, as
horizons. mentioned earlier, large inflation shocks can result in
larger unanticipated movements in asset prices. The linear
To illustrate these issues specifically, assume that the
instruments mentioned above cannot capture the
current inflation rate (as measured by the CPI) is 2.5%. We
convexity inherent in market responses to inflation spikes.
believe that dynamic asset allocation should be the first
This issue is especially important when initial inflation
line of defense in controlling against the initial and
levels and inflation expectations are very low. Second,
persistent rise in inflation, say for instance for a range of
hedging against inflation spikes by rebalancing alone
2.5% to 4%. This can be implemented by shifting the
would require a much higher than normal allocation to
allocation to inflation-sensitive assets. For example, it is
inflation-sensitive assets in the steady state. Since this
well established that outright long positions in traditional
portfolio rebalance has an implicit cost (in terms of lower
asset classes such as stocks and nominal bonds, in
nominal yields from underweighting nominal bonds, for
aggregate, deliver lackluster nominal returns under
example), the cost of a static inflation-sensitive portfolio
inflationary scenarios over short horizons (particular
using asset allocation alone would be a permanent drag if
combinations, such as yield curve steepeners, implemented
inflation spikes are not realized or inflation is not
by going short longer-dated bonds while hedging the
persistent. Inflation spikes are by definition low-probability
duration risk with shorter-dated bonds allow one to
events, thus the expected implicit cost of hedging from
benefit from rising inflation expectations). To be clear,
asset allocation should be compared with the potential
outright long positions in equities show a mixed sensitivity
benefits. Finally, and this follows from both the inherent
to inflation as the horizon changes. While in the short
instability of correlations of assets to inflation and the
term rising inflation risk premia (which accompany rising
trouble with forecasting inflation with accuracy, if instead
inflation) lead to an inverse relationship of equity returns
of inflation rising we actually realize deflation, a static
and inflation, over longer horizons, high earnings yield
asset allocation approach would prove to create large
(accompanied with high interest rates) may lead to positive
portfolio underperformance or at least additional tracking
correlations between inflation and equity expected returns.
error.
Alternative asset classes, such as Treasury Inflation-
Protected Securities (TIPS), gold, commodities, real estate For these reasons, if the object of hedging is to control
investment trusts (REITS), certain foreign currencies, against inflation tail risks, we believe a powerful approach
timber, intellectual property, farmland and long-short is to directly use an extension of the conceptual

MAY 2013 | VIEWPOINT 3

framework developed for equity/risky asset/deflationary
scenario tail risk hedging that commits a finite amount of
hedge “premium” to potentially inflation-sensitive
derivatives (see Bhansali, 2008). It relies heavily on
applying an option theoretic framework to hedging
inflation risk. To achieve these objectives in practice, the
framework relies on both linear and non-linear option-like
instruments across multiple asset classes. Surprisingly,
volatility across macroeconomic markets has been driven
to historical lows on the back of the supply of central bank
liquidity, and creates the opportunity, albeit short-lived, to
hold assets and hedge them too. So in our view today’s
macroeconomic environment creates an attractive set of
conditions for implementing inflation tail hedging relatively
inexpensively.
Tail hedging realized inflation versus inflation
expectations
The simplest metric for inflation risk is the percentage gain
or loss on a price index. In the U.S., the CPI is such a
metric. Inflation-linked securities such at TIPS derive their
value from the change in the CPI. Thus, to target inflation
risk management, the simplest dynamic approach would
be to create a portfolio of securities that are sensitive to
the CPI.
For instance, a direct linear hedge against inflation would
consist of inflation swaps, where one receives the inflation
rate measured by such an index in exchange for a
contractually fixed payment (these trade with a fair
amount of liquidity). Another alternative is to purchase an
inflation option, which typically trades in the form of
inflation caps (for rising inflation risk mitigation) and offers
more convexity if inflation starts to rise quickly. The caps
come in the form of year-over-year caps and zero-coupon
caps. Quite simply, year-over-year caps pay off if the
inflation measured over a yearly period exceeds a pre-
defined strike. Zero-coupon caps pay off if the actual value
of the inflation index (e.g., the CPI) exceeds a pre-defined
strike level of the index.
However, limiting to the observed CPI for inflation risk
management could be a rather restrictive way to manage
inflation tail risks, especially in today’s market
environment. There are two main reasons for this. First, a
cursory look at the components that make up the CPI
shows that a dominant portion (over 40%) is related to
housing and another major portion to food and energy.
Since the housing market is recovering from the excesses
of the crisis, and there is ample supply of housing to keep
inflation in this sector moderated, focusing on CPI inflation
could miss the impact of inflation in other sectors of the
economy. From a forward-looking and broader
perspective, macroeconomic considerations such as low
rates of capacity utilization can keep the short-term
inflation rate low, while longer-term inflation and inflation
expectations can rise due to policy, expectations and
uncertainty. Second, for longer-term investment decisions,
sensitivity to inflation expectations is likely to be a key
input. There are, of course, many metrics for inflation
expectations. One could use directly observable market
metrics such as the pricing of inflation swaps (though they
also carry exposure to counterparty risk and illiquidity). As
another alternative we could look at surveys (for instance
the Philadelphia Fed Survey of Professional Forecasters, or
the Thomson Reuters/University of Michigan Survey). As a
third option we could use implicit market metrics such as
the steepness of the Treasury yield curve or inflation break-
even rates. This last metric – that is, the inflation break-
even – is simply the difference between a nominal
government bond yield and the corresponding maturity
real yield.2
As can be observed in Figure 2, the 10-year break-even is
currently hovering around 2.5%.
2
However, two qualifiers are important before one takes this metric
seriously. First, the TIPS market is less liquid than the nominal
treasury market, hence some of the break-even spread is really a
liquidity differential. Second, given the purchase of both TIPS and
nominal bonds by the Fed, care needs to be exercised in relying on
the break-even rate as a pure metric of inflation expectations.
MAY 2013 | VIEWPOINT 4
 gauge that reflects in real time the inflation-fighting
FIGURE 1: CPI INFLATION IN THE U.S. FROM 1914 TO 2012
credibility of the Fed (Gurkaynak, 2006). So as an added
30 benefit this metric and the tail hedges on it are directly
25 related to the liquidity/inflation risk tradeoff that central
20
15 bankers are also paying close attention to.
Percentage

10
5 FIGURE 3: FIVE-YEAR FORWARD, FIVE-YEAR BREAK-EVEN
INFLATION FROM APRIL 2007 TO DECEMBER 2012
0
-5
3.5
-10
-15 3
-20
2.5
1914
1919
1925
1931
1937
1943
1949
1955
1961
1967
1973
1979
1985
1990
1996
2002
2008

Percentage
2
CPI YOY
1.5
Source: PIMCO 1
0.5
FIGURE 2: BREAK-EVEN 10-YEAR INFLATION FROM AUGUST
1998 TO DECEMBER 2012 0
Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12
3
Source: PIMCO and Bloomberg
2.5
2 So to recap: Using a linear instrument to protect against
Percentage

1.5 realized inflation we can use CPI swaps on the observed

1 inflation rate, or to protect against expected inflation we
0.5 can use the “four-legged” break-even (sell a 10-year
nominal and five-year real bonds and buy the five-year
0
nominal and 10-year real bonds) or their nonlinear option
-0.5
counterparts.
Aug-98
Aug-99
Aug-00
Aug-01
Aug-02
Aug-03
Aug-04
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
Aug-10
Aug-11
Aug-12

These linear instruments like swaps and break-evens are

always “delta-one” – that is, they will respond one-for-one
Source: PIMCO and Bloomberg
to changing inflation rates or inflation expectations. As
mentioned above, since both the swaps and the break-
If instead of using the spot yield differentials we use the
even trade can result in unlimited mark-to-market losses if
differential of forward yields, the result is the forward
inflation falls, the risk budget allocated to the hedge is
break-even rate. For example, the five-year forward, five-
hard to quantify ex-ante, as compared with that for their
year break-even is the difference between the nominal
option counterparts. To enter into such swaps
five-year forward, five-year yield and the real five-year
counterparties would require both maintenance and
forward, five-year yield (see Figure 3). Each five-year
variation margins against the mark-to-market volatility of
forward yield can be computed by observing the 10-year
the positions.
spot yield and the five-year spot yield and using traditional
compounding formulas for the yield curve. This forward The linear strategies are also always “at-the-money,” while
breakeven rate has also gained some notoriety as the there is more flexibility in picking the “strike” for the

MAY 2013 | VIEWPOINT 5

options-based strategies. Also note that we can combine
options-based strategies to reconstruct the linear
strategies, but not vice versa. In this sense the options-
based strategies allow for more customization of inflation-
protection portfolios.
Inflation dynamics and inflation spikes
Before we can dive deep into the quantitative aspects of
options-based inflation tail hedging, it makes sense to
explore briefly the theory and empirical properties of rising
inflation. We should note that both the economics and
empirical characteristics of inflation have been well studied
over multiple decades3, but forecasting bouts of high or
hyperinflation remains difficult as ever. In the interest of
focusing on practical methods for inflation tail hedging,
we will not discuss the fundamental economics of
inflation, but summarize the data on the time-series and
cross-sectional properties.
The two canonical examples of inflation super-spikes (with
episodes of high inflation present essentially in all
developed and developing economies over the last three
hundred years) are from the experiences of the Weimar
3
For instance, the time-tested Cagan model for hyperinflation is an
elegant framework that dates back to the 1960s. One consequence
of the model under a wide variety of assumptions is that
expectations of an uncontrolled and rapid increase of the supply of
money in the future will inevitably lead to an increase in inflationary
expectations.
Republic (early 1900s Germany) and Zimbabwe (late 1900s
early 2000s).4
While prices shot up 1 trillion times higher in terms of
marks, they remained stable in terms of gold, widely
considered to be an inflation hedge (source:
http://inflation.us/charts.html). In Zimbabwe the inflation
rate in August 2008 went up to 6.5 sextillion (10^21). In
effect, this meant the currency had no residual exchange
value.
While these anecdotes are interesting in their own right,
any currently popular inflation modeling paradigm does
not allow for the possibility of rapidly rising inflation, let
alone hyperinflation.
In the figures below we show inflation episodes in the U.S.
over the last 100 years. As is obvious, though there are
sustained periods of higher-than-normal inflation, the
actual experience in the developed markets recently has
not supported fears of very high inflation. Thus, any
empirically calibrated model for inflation to recent
experience would find the probability of hyperinflation to
be negligible.
4
There are numerous books and websites that discuss these historic
episodes. The website Shadow Government Stats has a
compendium of such anecdotes and further references.
MAY 2013 | VIEWPOINT 6
FIGURE 4: RECENT PERIODS OF HIGH AND PERSISTENT INFLATION IN THE U.S. AS MEASURED BY THE CPI

Number of Number of Number of Number of

Initial 1y End 1y
Initial CPI End CPI months in the months with 1y months with 1y months with 1y
∆CPI ∆CPI
period ∆CPI yoy > 2% ∆CPI yoy > 3% ∆CPI yoy > 4%
5/1973 – 1/1975 5.5 11.8 2.3 2.4 21 21 18 14
10/1978 – 6/1980 8.9 14.4 2.5 3.5 21 21 17 5
4/1987 – 1/1988 3.8 4 2.2 2.5 10 9 3 0
10/2007 – 9/2008 3.5 4.9 2.2 2.1 12 7 2 0
12/2009 – 9/2010 .7 1.1 2.6 2.4 10 9 2 0

Source: PIMCO

FIGURE 5: CPI INFLATION DISTRIBUTION IN THE U.S.

Tabulation of CPI_YOY
Date: 01/17/13 Time: 11:20
Sample: 1914M01 2012M12
Included observations: 1188
Number of categories: 9

Cumulative Cumulative
Value Count Percent count percent
[-0.2, -0.15) 1 0.08 1 0.08
[-0.15, -0.1) 22 1.85 23 1.94
[-0.1, -0.05) 29 2.44 52 4.38
[-0.05, 0) 114 9.60 166 13.97
[0, 0.05) 742 62.46 908 76.43
[0.05, 0.1) 163 13.72 1071 90.15
[0.1, 0.15) 78 6.57 1149 96.72
[0.15, 0.2) 31 2.61 1180 99.33
[0.2, 0.25) 8 0.67 1188 100.00
Total 1188 100.00 1188 100.00
Source: PIMCO
Hypothetical example for illustrative purposes only.

MAY 2013 | VIEWPOINT 7

The distribution of inflation over this super-secular period One of the reasons why rapidly rising inflation is out of the
has also shown no signs of being normal (see Figure 6). As zone of common expectations of current theoretical
a matter of fact, if one computes the raw probability of models is that inflation modeling has relied generally on
CPI inflation exceeding 5% per annum, the long history the same technology of continuous time finance that is
suggests that year-over-year inflation measured monthly used in the pricing of options on equities (where
exceeded 5% more than 20% of the time. Note, however, adjustments have to be made to explain tail behavior). In
that the low levels of realized inflation and low inflation one such popular model inflation rises to a certain level,
volatility as embedded in the pricing of inflation options but the further it deviates from a long-term average, the
(CPI options) suggest that the cumulative probability of more likely it is to revert back to the longer-term mean.
exceeding 5% inflation in one year is only 2.2%, in five This dynamic is ultimately based on the credibility of the
years is 6.4%, and in 10 years is 9.5%.5 So clearly the central bank not being challenged. If long-term inflation
“risk-neutral” pricing of inflation risk is not compatible expectations are anchored in this way and remain fixed,
with the very long history of realized inflation, unless we this class of models predicts that the mean and the
make the heroic assumption that credible monetary policy variance of inflation are always well behaved and converge
has the power to quash inflation and inflation expectations to a finite value; thus they cannot reach values that are out
unconditionally to keep them within a short range of of the ordinary with any large probability. Note that while
current levels. this approach is reasonable for modeling inflation under
well-behaved economic conditions, it might not be
FIGURE 6: PROBABILITY OF EXCEEDING INFLATION BASED
appropriate under the presently observed economic
ON EMPIRICAL INFLATION DISTRIBUTION IN THE U.S. FOR
THE LAST 100 YEARS conditions, low realized and expected inflation and
policymaker activism, not to speak of the increasing
CPI YOY range Probability of exceeding
challenges to the notion of central bank independence
2.50% 54%
3.50% 38.60%
and credibility.
4.50% 27.70%
Another similar approach, more econometrically motivated
5.50% 21.60%
6.50% 17.32% but still backward-looking and rooted in empirical data
7.50% 14.50% analysis, is to model year-over-year inflation as an
8.50% 12.80%
autoregressive process. The economic rationale behind this
9.50% 10.90%
10.50% 9.00% assumption of “inertia” is that rising inflation results in a
11.50% 7.40% recalibration of expectations, and hence inflation rate
12.50% 5.90% changes show momentum; that is, rising or falling inflation
13.50% 4.60%
14.50% 3.90%
is likely to be followed by rising or falling inflation.6 Thus
15.50% 3.20% discontinuous changes, especially reversals, cannot be
16.50% 3.00% accounted for within this approach either.
17.50% 2.50%
18.50% 1.70% Abandoning the assumptions of continuity, at the other
19.50% 1%

Source: PIMCO. CPI inflation data from 1914 to 2012.

Hypothetical example for illustrative purposes only.
5
Please see Barclays Inflation Volatility Digest, January 2013.
6
If one naively fits the CPI YOY inflation series to an AR(1) process
(i.e., with one lag), the dependence on the first lag is almost 0.98%,
so there is indeed a lot of momentum in inflation as measured over
short periods.

MAY 2013 | VIEWPOINT 8

extreme we can model the inflation process as a
compound jump process. A compound jump process
combines randomly occurring jumps with randomly
distributed magnitudes of jumps. The easiest approach to
simulate assumes that inflationary jumps occur randomly,
following, for instance, a Poisson process, and the size of
the jumps is also random (for instance the size of the
shocks can be normally distributed about a mean jump
size).7
model, a normal distribution or even a calibrated jump
process. What this suggests is that while modeling
inflation dynamics with an eye toward tail hedging, we
might have to make a larger leap than any of the
traditional models would allow.
FIGURE 7: EMPIRICAL AND THEORETICAL INFLATION RATE
DISTRIBUTIONS

The modeling of hyperinflation from a purely

macroeconomics viewpoint is based on the classical
quantity theory of money, which relates money times the
velocity (circulation) of money to price times economic
output (i.e.,
×  =  × ). Under this theory, holding all
else constant, if the supply of money increases, then the
price level has to increase. The expected increase of the
money supply (i.e., under the promise of continued central
bank quantitative easing, so-called  ∞) would result in
such an outcome for inflation expectations.8
Source: Distribution of realized CPI using various fitting algorithms from 1914 to
We do not believe that any of these simplified dynamics 2012. Hypothetical example for illustrative purposes only. Blue line is a
are the complete and unique answer to modeling inflation, kernel fit to the actual YOY CPI inflation. The green line is the normal distribution
with long-term mean and standard deviation from realized inflation. The yellow line
let alone to forecasting its future evolution. Indeed, none
is from a compound jump process, and the red line distribution is from an
of these theoretical approaches does very well in fitting autoregressive AR(1) model. None of the theoretical models can explain the fat tails
the actual distribution, especially the tails of the inflation in realized inflation.
distribution. Given the inability of these models to fit
Framework for inflation tail hedging
actual experience both in the U.S. and elsewhere, pinning
too much faith on inflation hedging strategies on such Given that there are severe limitations in forecasting the
foundations is likely to prove erroneous for practical dynamics of inflation, we take the view that investors
portfolio construction. ought to be less concerned about forecasting the
probability of inflation spikes and more concerned about
As Figure 7 shows, the empirical distribution of realized the severity of such events and their impact on portfolios.
inflation is much fatter-tailed than an auto-regressive This “Pascal’s wager” approach to tail risk hedging
necessarily forces us to reflect on the exposures within the
7
This is exactly the same as a Merton jump process that has been portfolio to construct the hedging program.9
utilized for the modeling of fat tails and the volatility skew for equity
markets.
8
Critics of the quantity theory of money would argue that
hyperinflation only results if there is an accompanying supply shock, 9
for example, shocks that arise from wars or famines, but these Pascal’s wager in this context simply means that since expected
nuances are really irrelevant for our task at hand of creating losses are the probability of loss times the severity of loss, we should
portfolios robust to rapidly rising inflation or inflation expectations. behave as if we cannot forecast the probability, since the severity of
the event can easily overwhelm any minor differences in the

MAY 2013 | VIEWPOINT 9

We also believe that any tail-hedging program is best
implemented with reference to the underlying asset and
liability portfolio being hedged. This holistic picture allows
for active management, proper accounting of hedging
costs and the ability to rebalance opportunistically. This
asset allocation perspective also makes it possible for the
tail-hedged portfolio to perform better over long-term
horizons, since inflation tails, by definition, are low-
frequency but high-severity events, and excessive reliance
on our ability to forecast the timing of such events is
fraught with danger.
Three essential ingredients are critical to the understanding
of any tail-hedging program, whether for the equity type
of risk, or more relevant to the current discussion, for
interest rate or inflation sensitivity. First, we need to
understand portfolio risk exposures. As is well known, for
fixed income portfolios, we can condense and encapsulate
the exposures in terms of a handful of key risk factors. The
most important ones are duration, curve duration
(sensitivity to yield curve steepening and flattening), spread
duration (sensitivity to OAS changes) and convexity. Of
these, the primary risk factor is duration. For equity-heavy
portfolios, it is various equity factors, such as betas (overall
market betas, growth, value, etc.). For a blended portfolio,
a look-through into both these factor exposures is
important. Just as high-yield bonds carry a substantial
amount of equity beta, many risky assets thought of as
pure equities carry a large amount of inflation or duration
exposure. For example, think of utility sector equities that
are exposed to economic cycles and interest rate levels, or
even the financial sector, which is exposed to the level of
interest rates as well as the shape of the yield curve (since
financial sector companies derive profits primarily from
borrowing short and lending long – the “carry” trade).
Second, we need to specify tail risk “attachment levels.”
For hedging purposes, the attachment level is simply the
probability forecast error. Pascal used this logic in the context of
whether one should believe in the existence of God.
level of inflation or interest rates beyond which we want
the portfolio to be protected. If we estimate the duration
of a portfolio to be five years (e.g., for a portfolio similar to
the Barclays U.S. Aggregate Bond Index), then a 100-basis-
point rise in yields (say from inflation) would result in
roughly a 5% fall in the value of such a portfolio. So we
can translate easily from the portfolio loss tolerance to the
attachment level in terms of inflation if we assume a pass-
through from inflation to interest rates.
Third, we need to specify the horizon of the tail hedge. Is
the hedge for a “cyclical” six-month horizon, or for a
“secular,” say five-year or even longer horizon? Since
inflation is much lower frequency and longer lasting than
equity market shocks, we believe that inflation tail hedging
horizons necessarily have to be longer than those for
equity market tail hedging. As we will discuss further
below, the longer the horizon, the more confidence we
can have in forecasting correlations with indirect hedging
assets, which we can also use in our favor for building
more efficient hedges.
Finally, we need to have some estimate of the cost of the
hedge and whether the budget will be used up front or on
an ongoing basis.
Obviously these inputs have to be iterated to find
appropriately priced hedges in the market, or the
parameters have to be varied until a suitable exposure,
attachment and cost can be found. For instance, if the
attachment level is too close to the current level of rates,
and the cost budget is not large enough, then either the
duration exposure has to be reduced by portfolio
repositioning, or cheaper, indirect hedges have to be
utilized.
Benchmarking inflation tail hedges
When we discuss tail hedging for typical equity-like risks,
we find it important to define a benchmark hedge that we
can call the “direct” hedge as reference. For instance, let
us look to hedge the equity component of a 60%
equity/40% bond portfolio at an attachment level of 15%
of the portfolio value (i.e., when the portfolio falls 15% or
MAY 2013 | VIEWPOINT 10
more it is hedged) for one year. The reference hedge is these options, the market convention is to assume that the
approximately a 25% out-of-the-money equity put on CPI index itself is a lognormal variable. Sample term sheets
60% of the notional for the same one-year maturity (since for these options are provided below.
the 60% equity component would have to fall by
15%/0.60 = 25% to reach the attachment level if the rest FIGURE 8: EXAMPLE OF INDICATIVE TERMS FOR A ZERO-
COUPON CPI CAP11
of the portfolio was unchanged). We can directly price this
option using the price of an index option that replicates
the equity component. Of course if volatilities are high, Option type CAP
then the hedge might be too expensive, and one might
Notional amount USD $100,000,000.00
make the decision to reduce the total size of the hedge,
Inflation index CPURNSA
look at correlated “indirect” hedges or actively manage
the quality (strikes, maturities, mixes) of the hedges. For Inflation based index CPURNSA for November 2012
inflation hedges, we can take the same approach. We can Strike inflation rate 5%
either benchmark the hedge in terms of the total expected
Premium X bps
payoff if the CPI (or the five-year forward, five-year break-
even as an alternative) rises beyond a particular level. Or
we can price the theoretical CPI cap or break-even option Trade date 1/30/2013
and then try to make the actual hedge more attractive Premium payment date 2/1/2013
relative to the direct inflation hedge. This exercise in
Effective date 2/1/2013
benchmarking leads us to a brief discussion of the pricing
of inflation options. Maturity date 2/1/2013

Date convention Modified following business day, as

Pricing of inflation options
determined by New York and London
While options on both realized and expected inflation holidays
currently do not have liquid markets, we find it instructive
Schedule of payment
to use this pricing for setting a theoretical “benchmark.”
To this end, we go through the steps of pricing a CPI Party A (buyer):
Party B (writer):
option and a break-even option.10
Party A pays and Party B receives:
Options on the CPI
USD $ [X bps * Notional] on the Premium Payment Date
To set the stage, we first compute the pricing of options
Party A receives and Party B pays:
on the CPI index (CPURNSA on Bloomberg). These options
Notional * Max[ 0, Inflation Adjustment - (1 + Strike Rate)^10 ]
come in two forms. The first form is the zero-coupon (ZC) on Maturity Date
option on the cumulative CPI. The second form is an
Inflation adjustment will be defined as USCPI (N) / Inflation Base
option on year-over-year CPI inflation (YOY). To price
Index, where USCPI (N) is the CPURNSA published three months
prior to the maturity date.
10
For a robust hedge construction, we also need to manage the
counterparty risk of the OTC options, and carefully select the Source: PIMCO, Bloomberg.
currency in which the hedge payment will be made. In the extreme Hypothetical example for illustrative purposes only
case, if the settlement for a dollar inflation option is in less valuable
dollars, the price of the inflation hedge has to be appropriately
11
adjusted. This quanto adjustment is standard. Source: Deutsche Bank.

MAY 2013 | VIEWPOINT 11

FIGURE 9: EXAMPLE OF INDICATIVE TERMS FOR A YOY CPI
As of December 2012, the index had a value of 230.221.
CAP12 The forward CPI for one year, using data from the survey
of professional forecasters, was 238.28 (using a CPI YOY
forecast of 3.5%). If we assume that the last 12 months’
Option type CAP
volatility of the CPI is a good estimate of volatility for
Notional amount USD $100,000,000.00 option pricing, we can compute an annualized volatility of
Inflation index CPURNSA approximately 1.5% as an input (although note this
volatility has been quite variable, and some practitioners
CPURNSA Index level three months
Inflation based index use the volatility implied from the implicit floor in TIPS
prior to the effective date
prices to price such options).
Strike inflation rate 4%
Using these inputs, an at-the-money forward CPI option
Premium Y bps
for one year would cost 1.24% (of notional). Similarly, a
1% out-of-the-money option would cost 62 bps, and a
Trade date 1/30/2013 2% out-of-the-money option would cost 24 bps. From
Premium payment date 2/1/2013 1968 onward, the average annualized volatility of the CPI
has been approximately 1.15%, so the average price of an
Effective date 2/1/2013
at-the-money option at the theoretical volatility would be
Maturity date 2/1/2018 (5 years) approximately 0.5%. Similarly, the average theoretical
Roll date Feb 1st, annually price of a 1% out-of-the-money CPI option would be 19
bps, and that of a 2% out-of-the-money CPI option would
Date convention Modified following business day, as
determined by New York and London be approximately 8 bps.
holidays Just to be clear, market participants also quote the
Schedule of payment volatility in terms of bps/day for inflation option pricing. If
Party A (buyer): at-the-money volatility is 1.5% for the CPI, this translates
Party B (writer): roughly to volatility of 10 bps per day. This increases to 2
bps per day more (or 180 bps per annum) for a 5% strike
Party A pays and Party B receives:
cap, reflecting the “skew” in the pricing of inflation
Notional Amount * Y bps on the Premium Payment Date
options (Mirani et. al., 2013). Of course we do not doubt
Party A receives and Party B pays (on roll dates):
that the pricing will be variable based on models and
USD 100,000,000.00 * Max [0, Inflation adjustment -4%]
demand and supply considerations, but having these
Inflation adjustment will be defined as: USCPI(N) / USCPI(N-1)-1 estimates allows us to do basic analysis in terms of the
Where: USCPI(N) is the inflation index published three months relative richness or cheapness of these “straight” hedging
prior to the payment of the Nth period and USCPI(N-1) the one
alternatives.
published 15 months prior to the payment of the Nth period.
Options on the break-even inflation rate13
Source: PIMCO, Bloomberg.
Hypothetical example for illustrative purposes only In a similar vein, as discussed above, if we are concerned

13
I am grateful to my colleague Mitch Handa for the computations
12
Source: Deutsche Bank. in this section.

MAY 2013 | VIEWPOINT 12

that the rise in inflation expectations needs to be hedged,
we need to price options not on the current CPI or
inflation rate, but on longer-term inflation expectations.
We believe the best metric (of many such metrics, none of
which is really perfect), as displayed above (and watched
by the Fed), is the forward inflation rate as embedded in
the pricing of nominal and inflation-linked bonds. The
theoretical benchmark pricing of options on these break-
evens is slightly more involved and, to be clear, these
options do not currently trade.
Suppose we take the current five-year forward, five-year
break-even to be 3%, and we want to price an option on
the break-even struck at 4%. To price this option, we will
require the volatility of the break-even rate itself. The
difficulty is that options on the break-even do not trade in
the market currently, so there is no direct way of inferring
the break-even volatility. One alternative is to use
historically realized break-even volatility. The historical
estimate (since 2007) of the volatility of the five-year
forward, five-year break-even is approximately 100 bps a
year.
The other alternative is to use the fact that the break-even
rate is basically the difference between the nominal and
the real yields. The variance of the break-even can be
estimated if we can use the volatility of the nominal rates
and the real rates and the correlation between them. The
nominal rate volatility can be read off from the actively
traded swaption market (it’s of the order of 80 bps to 100
bps per year). The volatility of the real rate can also be
implied out of options on TIPs (called TIPtions), but these
options again don’t trade with much volume or liquidity.
To make things simple, we assume that we can forecast
real rate volatility (which should ultimately be related to
real growth rate variability).
As an illustrative example, if we assume that the volatility
of the real yield is 75 bps per annum, and the correlation
between the real yield and the nominal yield is 70%, then
we obtain an estimate of the volatility of the forward
break-even of approximately 65 bps per year using the
formula relating the variances. We can now use this
volatility as an input in the pricing of a break-even call
option. An option struck 100 bps out of the money (say at
a forward break-even rate of 4%) would cost
approximately 96 basis points up front. If we annualize this
number, the cost is approximately one-fifth or 20 bps per
year. In practice, there is likely to be a substantial skew to
the volatility surface; that is, since the volatility of inflation
is expected to be higher for higher inflation, the input
volatility for a deeply out-of-the-money call option on the
break-even is likely to be closer to 100 bps.14
As mentioned above, these computations for both the CPI
and the break-even option are largely theoretical as of this
writing, since break-even options really do not trade in any
real volume. But the real value of benchmarking the price
of these options is to set a reference for indirect hedging
of inflation tail risk. To replicate the payoff of such direct
options we have to create proxy or “indirect” hedges,
whose relative attractiveness might be graded with
reference to the theoretical “direct” options. We will
discuss this approach now.
Indirect inflation tail risk hedging and basis risk
Given that many direct inflation tail options are practically
not implementable, we now turn our focus to
approximations. We will do this systematically, but starting
with underlying assets that are fundamentally most
correlated to inflation, and then to assets that have less
predictable co-movements with inflation under normal
situations but high co-movements especially under
inflation shocks.
While it may seem that our task would be done if we can
find assets that show a high positive beta to inflation by
doing a simple correlation analysis, it is important as
mentioned above to note that the potency of an inflation
14
The simplest way to use this in the pricing of break-even options is
to use a class of models knows as SABR (Stochastic Alpha Beta Rho),
where both the inflation variable, either the CPI or the break-even
rate, and the respective volatility are stochastic and the inflation
variable and the volatility have a positive correlation.
MAY 2013 | VIEWPOINT 13
hedge also depends on the persistence of inflation. Since
inflation itself is a low frequency time process,
incorporating inflation persistence in estimation of the
hedge betas is critical before we select hedges. We will
briefly discuss the role of inflation persistence in
determining the potency of hedges.
Following the framework of Schotman and Schweitzer
(2000), if inflation evolves as an autoregressive process
(with the caveats discussed previously on making this
assumption),
though the short-term behavior of indirect inflation tail
hedges might be open to much debate, the potential
longer-term benefits of a diversified basket of inflation tail
hedges, purchased at an attractive price, are quite
predictable. We invite the curious reader to plug in some
sample parameters into the equations above to see the
time behavior of inflation hedges. This also cautions us
that the traditional approach of using contemporaneous
correlations between asset returns and inflation leaves us
short of extracting all the value we can from the role of
these assets as inexpensive longer term hedging vehicles.

 =  + 
− ) + 

Pricing of tail interest rate swaptions
and asset returns are a function of expected and
Our first step toward deriving an indirect hedge is to
unexpected inflation
assume that the effect of rising inflation is reflected in

 =  +      +  +  rising nominal interest rates while real rates remain
(where , , , _, _ are inflation persistence, inflation
beta of asset, beta of returns to unexpected inflation,
return volatility and inflation volatility), then the estimate
of the long-term beta (the “hedge ratio”) of the hedge is
"1 − ) + $%&
Δ= &
1 − )& '& + "1 − ) + $ (&
which requires "1 − ) + $ > 0 for the hedge to be a
bona-fide hedge (i.e., for the beta to be positive to
inflation).
Equally important is the case when inflation becomes a
random walk, that is
relatively static. If this assumption is borne out, then
options on the nominal yield curve (i.e., swaptions) would
be the simplest replication of the option on the break-even
inflation. Indeed, as a matter of practice, we have recently
observed that many inflation tail hedgers have been using
“out-of-the-money” swaption hedges (which explains the
“payer” skew for swaption volatilities).
Here is an example of the pricing of a payer swaption (the
right to pay fixed swap rates at a pre-defined strike).
Assume that the current five-year forward, five-year swap
rate is 2.97%. Suppose we fix the premium budget at 50
bps per year, which equals 2.50% for the next five years.
Using a Black model for swaptions and an implied volatility
 =  +  of 95 bps, we can price the option and solve for the strike
that this cumulative premium gets us (the strike turns out
Then for any time-horizon +, the estimate of the hedge to be 3.64%). The distance of this strike from the current
beta is value of the forward is 0.67%. Based on a Black model the
  delta of the swaption turns out to be 0.38. To evaluate the
, + + − 1) + ) + + − 1)2+ − 1/ )%&
& -
Δ = 
potency of this hedge in a portfolio and perform risk
'& + , & + + − 1) + + − 1)2+ − 1) & / %& analysis, we can shock the interest rate curves and re-
-

If we were to plot this hedge ratio as a function of the evaluate the new value for the portfolio with and without
time horizon + we would find that the hedge potency the hedges. This exercise is quite standard and most of the
increases monotonically but at a decreasing rate as a computations can be done with ease.
function of the horizon. What this tells us is that even Note that swaptions allow the customization of both the

MAY 2013 | VIEWPOINT 14

option expiry and the rate (underlying) of the hedge. If one
is worried about inflation rising in the short term and the
short end of the nominal curve reacting to it, shorter-
dated swaptions (say one-year expiry into the five-year
swap curve) can be used. On the other hand, if we think
that the rise of inflation will be a gradual process and
really happen through expectations changing, then longer
options (say 10-year options on the 10-year swap) might
be warranted. In doing so, swaptions allow for an implicit
view on the impact of rising inflation or inflation
expectations on the shape of the yield curve to be
simultaneously expressed with the most attractive point to
buy volatility. In the current environment, the swaption
volatility curve illustrates a “hump”; that is, it peaks
around the two-to five-year point and declines both for
shorter- and longer-dated swaptions. This allows for
efficient volatility positioning as well. For instance, the
purchase of a long-dated swaption results in volatility
“roll-up”; that is, as time passes the longer-dated
swaption becomes a shorter-dated swaption with a higher
implied volatility. In doing so, the natural time decay
incurred as part of buying an option is reduced. Any active
inflation tail risk management paradigm should pay
attention to such opportunities in the volatility term
structure.
As we move further afield from interest rate options such
as swaptions, we are faced with the problem of
forecasting the correlations between these instruments
and the rise in inflation and especially the robustness of
the correlations. Theoretically, we can try to anticipate
which assets are likely to have positive inflation sensitivity
by noting that the value of any asset is the expected NPV
of its future cash flows. If the NPV is calculated using the
discount factor given by 0 = 1 23
4) , where  is the real two series are highly correlated, especially in the extremes.
rate, 5 is the inflation rate and 6 is the risk premium or
credit risk, then we can see that the lower the sum of the
three, the higher the discount factor. We can empirically
partition the returns of any asset into their exposure to
these risk factors and keep the inflation-sensitive
component as a hedge. If we linearize the above equation
by expanding the exponential, essentially what we are
looking for are asset classes and combinations of securities
that will show a positive relationship with inflation. To
evaluate this, we looked at various inflationary periods and
some core inflation-sensitive asset classes. Over most
periods, it is clear that amongst other proxy instruments,
gold and oil have tracked both realized and expected
inflation fairly well, especially when we adjust for the
persistence effect mentioned above.
While some assets like gold clearly show persistent positive
relationships to rising inflation, especially if we condition
our analysis on large rises in inflation, the paucity of data
for periods similar to the current era makes dependence
on backward-looking data analysis dangerous. To address
this issue, we take a three-step approach. First we forecast
which assets qualitatively are expected to respond to
inflation in a dependable manner. Second, we estimate
the relative cost of inflation-protection options on these
assets against the cost of the more direct hedges. Finally,
we iterate different mixes of such options in the portfolio
to arrive at a probability distribution of possible outcomes
that captures the basis risk versus the relative cheapening
of the hedges compared with the most direct hedge. The
spectrum of combinations measured through the lens of
the cost versus basis risk allows a practical hedge program
to select what point of the spectrum is appropriate.
Gold and oil as proxy hedges
As an example of indirect hedges that we can build
theoretical and empirical support for, we can look at gold,
crude oil and some foreign currencies as proxy hedges.
Even a cursory look at the historical returns on the CPI
(YOY) and year-over-year returns on gold shows that the
Other than the empirical correlations (which happen to be
close to 0.5 for inflationary episodes), there are good
fundamental reasons to believe that gold and oil are
robust inflation tail hedges. Simplistically put, if central
banks are printing money to devalue their currencies, then
gold, which is in limited supply and “the currency of no
MAY 2013 | VIEWPOINT 15
one central bank,” is clearly the beneficiary. In addition,
there is anecdotal evidence that central banks are
generally underweight gold as an asset, and a rebalancing
toward reducing this underweight could easily be
correlated with an inflation shock (see Erb and Harvey,
2012). While the empirical beta and the correlation are
highly variable, we can easily see for fundamental reasons
why options on gold at proper valuation levels can prove
to be potent indirect hedges for both realized and
expected inflation. For crude oil, the relationship might
indeed be even more fundamental than it is for gold. First,
a rise in oil prices has a direct flow-through into the pricing
of finished products, both due to the energy cost of
production and also because many oil derivatives are
actually components of consumer products. Shocks to
energy supply are also naturally positively correlated to
rising inflation and inflation expectations. If we follow the
supply shock argument as the precursor to inflation, then
the case for energy-related assets, especially oil, as tail
hedges becomes stronger.
Example of gold options as a proxy tail hedge
For this section, we will sketch the indirect tail hedging
exercise with gold. We can easily extend the analysis to
options on oil in a parallel fashion.
Let us return to the example discussed above, where we
priced a CPI call option for one year at a theoretical price
of 24 bps for a 2% out-of-the-money attachment point.
We also priced an option on the five-year forward, five-
year break-even for approximately 20 basis points a year.
We will focus on comparing the break-even option with
the gold option as an indirect hedge.
To show how the computation of gold as a proxy hedge
works, we first estimate the comparable attachment point
in gold terms. If, for instance, we believe the conditional
tail correlation between gold and the CPI to be 0.8, and
assume that the volatility of gold for one year is 15% (we
could read this from option-implied volatilities on gold, for
instance), then we can approximate the beta of gold to
CPI to be approximately the volatility ratio of gold to the
CPI times the correlation. With this predicted beta of eight,
we can see that a theoretical call option on gold will
require a strike price that is scaled to be proportionately
further away. In other words, in percentage terms we
want the strike of the gold call option to be eight times
away from the equivalent strike for the direct inflation
option. The price of this indirect option is easy to obtain
from the market. However, we still need to figure out how
much of the indirect option to buy.
Thus, the second step is to compute the future value of
both the inflation option and the gold option conditional
on the inflation variable crossing the targeted inflation
attachment point and scaling the size of the gold option
such that when such an event happens their future dollar
values are equal. This step is necessary to make sure that
the indirect option can be exchanged with a high degree
of certainty against the theoretical inflation option at that
unknown (random) future date. This step also allows us to
measure the potential basis risk from selecting an indirect
hedge. The final step in the analysis is to compare the
present price of this appropriately scaled indirect gold
option against the price of the direct inflation option.
Continuing with our example, suppose the break-even
option crosses the threshold of a 4% inflation rate in six
months. Assuming that the volatility of the 4.5-year
forward now increases to 100 bps/year (see the discussion
of skew above), the new price of the theoretical break-
even option is 384 bps; that is, the initial 96 bps has
realized a mark-to-market gain of 3x and is now worth 4x
its original value. So the proper way to scale the gold call
option is such that its dollar value increases to the same
amount. Of course, ultimately we need to apply judgment
on how much of the ultimate hedging portfolio should
consist of indirect hedges. To achieve this, we include the
mix of direct and indirect options in the portfolio at
different weights and compute the distribution of scenario
payoffs versus costs. This tradeoff of basis risk versus cost
savings is standard for any tail-hedging practice, and
ultimately is one that the end user has to make based on
considerations of the desire for certainty in hedge
MAY 2013 | VIEWPOINT 16
performance against the budget available. introduced direct, non-linear options on both realized and
expected inflation. Unfortunately, since these options do
The longer the time for crossing the threshold, the more
not have a liquid market at the time of this writing, we
certain we can be that the indirect hedges will actually
must work with approximations to the direct hedges. To
realize the tail correlation that we theoretically expect
do so we first laid out the key elements for building an
them to. In other words, the basis risk of indirect hedges is
inflation tail hedging program, using benchmarks,
effectively reduced as the horizon of hedging increases.
exposures, attachment points, cost and basis risks as
Conclusions parameters. Finally, we illustrated, by simple examples,
The unprecedented creation of liquidity in the aftermath of how to incorporate indirect hedges from other asset
the credit crisis, the massive debt burden emanating from classes.
this liquidity and the well-advertised and potent threat of
In summary, there is macroeconomic need today for crude
inflation-loving central banks raise the risk of an
yet potent inflation hedging solutions. Whereas the
unanticipated inflationary tail event. Whereas a spike in
actions of central banks have possibly mitigated short-term
actual inflation is not impossible, the magnitude of adverse
deflation risk and risk to equity markets, in their wake
impact to investment portfolios is likely to be tied to an
inflation and duration tail risk are not far behind. We
unanticipated increase in inflationary expectations. In this
believe that the framework of this paper can be used to
paper, we discussed how to systematically address
create a portfolio of potent hedges against such an
inflation-tail hedging via the framework that we have been
adverse tail event.
able to apply to equity market risks. To do so, we first

MAY 2013 | VIEWPOINT 17

Acknowledgements
I would like to thank my colleagues at PIMCO for their collaboration and critical comments on
the draft of this paper. Chris Dialynas read an earlier version of this paper and made many
helpful comments and pointed to other historical research. Mitch Handa and Qingxi Wang
helped with the pricing of inflation options. Josh Davis and Bruce Brittain have assisted in
developing our tail risk hedging approach, of which this is the latest iteration. I would also like
to thank many clients who have asked for thought and discussion on the topic of tail risk
hedging of inflation risk.

References
Bhansali, Vineer (2008). “Tail Risk Management,” The Journal of Portfolio Management,
Summer, Vol. 34, No. 4, pp 68-75.
Erb, Claude, and C.R. Harvey (2012). “The Golden Dilemma,” available on SSRN website.
Gordon, Robert J., and vanGoethem, Todd (2007). “Downward Bias in the Most Important CPI
Component: The Case of Rental Shelter, 1914-2003,” Hard-to-Measure Goods and Services:
Essays in Honor of Zvi Griliches, University of Chicago.
Gurkaynak, Refet S., Sack, Brian, and Wright, Jonathan H. (2008). “The TIPS Yield Curve and
Inflation Compensation,” Finance and Economics Discussion Series. FRB, 2008-05.
Johnson, Nicholas, Walny, Ronit (2013). “Responding to Inflation: A Multi-Asset Approach,”
PIMCO Strategy Spotlight, January.
Johnson, Nicholas (2012). “Practical Models for Inflation Forecasting,” Inflation Sensitive Assets,
Risk Books, pp 351.
C. Mirani et. al. (2013). “Inflation Volatility Digest,” Barclays Interest Rate Research, January 29.
Schotman, Peter C., and Schweitzer, Mark (2000). “Horizon Sensitivity of the Inflation Hedge
of Stocks,” Journal of Empirical Finance, Vol. 7, pp 301-315.

MAY 2013 | VIEWPOINT 18

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Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is
subject to certain risks, including market, interest rate, issuer, credit and inflation risk. Investing in foreign-denominated Hong Kong
and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks,
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invest directly in an unmanaged index.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to
change without notice. This material is distributed for informational purposes only and should not be considered as investment
advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been
obtained from sources believed to be reliable, but not guaranteed.

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Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market Sydney
conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by
foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain
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