An inflation hedge is an asset which is designed to insure against the risk associated with rises in the average price of goods and services. In finance and economics, another term used to describe rising prices is inflation. In general, inflation increases by approximately 3 percent every year. This means the price of goods and services goes up approximately 3 percent every year. In finance, the word hedge is used synonymously with the word insurance.
Since changes in inflation are relatively small from year to year, the need for an inflation hedge increases with long-term investments. The effects of long-term inflation are felt most in portfolios with long-term bonds. T-bills, because of their short-term nature, are considered to be a hedge against inflation. T-bills, however, offer little return over the long-term.
It is important to clearly understand how inflation erodes investment value over time — the link is not entirely intuitive. If inflation increases 3.0 percent every year, an asset which is valued at $100 U.S. Dollars (USD) today will be priced at $130 USD in ten years. There is no change in the actual value of the asset. The result is decreased purchasing power for the investor. An inflationary hedge may help to mitigate this risk.
Creating a hedge against inflation means finding a product that helps to combat price increases. Developing countries are prone to having exponential inflation, which is referred to as hyperinflation. This occurred in Germany in the 1920's and in many South American countries in the 1990's.
The effect of hyperinflation is a rapid devaluation of a nation's currency. This can also lead to economic and political chaos. Hyperinflation triggers a host of changes in the economy which all work to erode the value of assets over time.
One way portfolio managers manage inflationary risk is with inflation hedge products. There are several different types of products which offer an inflation hedge. Many natural resources or commodities are not directly tied to currency. As a result, commodities are not directly affected by an increase in prices. Common commodities used to create an inflation hedge are oil, agricultural products, and metals.
In general, when inflation increases, people become weary of placing too much faith in paper money. As a result, they will purchase hard assets which can be sold across nations. Natural resources are also produced around the world. As such, the demand is global and not tied to any one particular economy. Stock in companies which sell or trade in natural resources can also act as an inflation hedge.