On the Limits of Hedging Inflation Risk in Investment Portfolios

Working paper 858
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Published: 10 April 2026

By: Damiaan Chen Roel Beetsma Sweder van Wijnbergen

We explore to what extent real returns on investment portfolios can be hedged against inflation risk by using existing financial market instruments. We empirically find that inflation-linked bonds offer only limited protection against inflation risk, while nominal debt and stocks play at least comparable roles in this respect. These findings apply to both a static and a dynamic setting. To explain the empirical results, we develop a theoretical framework that incorporates real basis risk. The demonstrated limits of hedging inflation risk are of particular relevance for long-term investors, such as pension funds with participants concerned about the real value of their pension benefits.

Keywords: unhedgeable inflation risk; incomplete markets; welfare loss; meanvariance frontiers; minimum-variance portfolio; nominal and index-linked bonds;
JEL codes C61; E21; G11; G23;

Working paper no. 858

858 - On the Limits of Hedging Inflation Risk in Investment Portfolios

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Research highlights: 

  • Minimum-variance portfolios fail to eliminate inflation risk, even when inflation-linked bonds (ILBs) are included.
  • Nominal bonds and equities provided inflation hedging over 2004-2024 that was at least as effective as ILBs, challenging conventional assumptions.
  • The role of ILBs in hedging inflation risk increases during high-inflation periods, but broad asset class diversification remains essential for achieving stable real returns.
  • A theoretical model with time-varying real basis risk rationalizes the limited hedge effectiveness of ILBs and the observed prominence of nominal bonds and equities.
  • Diversification across asset classes enhances long-term real return stability and significantly improves investor welfare, particularly for long-horizon investors.

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