Because of the relatively high volatility associated with emerging market currencies, the decision of whether or not to hedge an EM bond position is critical. The issue is particularly complex for inflation-linked bonds. For 9 out of the 10 EM countries we analyzed, there exists a statistically-significant inflation pass-through effect from exchange rate returns. Further, this relationship extends to inflation-linked bond returns. Specifically, ILB returns are negatively correlated to currency returns at 6-month time intervals and ILB returns are particularly sensitive to currency depreciations. This diversification results in a reduction in the volatility of an unhedged ILB position at a 6-month horizon, relative to the zero correlation case. For multiple levels of volatility, the currency-ILB diversification benefit results in a reduction in the hedge ratio, implying that investors can achieve similar volatility with perhaps a lower currency hedge ratio than originally thought.
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