Effective hedges against inflation for pension funds

Dutch pension funds that index their pension liabilities to wage inflation commonly use the inflation linked derivatives based on the Harmonized Index of Consumer Prices (HICP) as a best proxy for wage inflation. This thesis provides a justification for this strategy and the assumptions under which this strategy can be adopted. By using the techniques of panel co-integration and vector error correction we establish that wages and prices are co-integrated. The nominal wage adjusts to changes in price by a factor slightly more than one in the long-run. Under the assumptions- (i) that the emergence of HICP as a new measure of inflation does not alter the behaviour of economic agents, and (ii) the longrun co-integration equation assumes a trend, this implies that for pension funds that index their pension liabilities to wage inflation, derivatives based on HICP are effective hedges in the long-run. Presence of co-integration ensures that basis risk is minimized in long-run. We also demonstrate that current ALM framework which models the long-run as a series short period as against the cointegration framework that views long-run as one time block can give very different outcome. The current ALM framework needs modifications to incorporate the long term characteristics of pension funds. We also argue that, the co-integration framework can be useful in finding cost-effective hedges for non-tradable risks like wage inflation.