Research On Using Steel Futures To Hedge The Inflation Risk On Chinese Treasury Bond

With the continuous deepening of China's interest rate marketization and the improvement of financial openness,the Chinese bond market,especially the treasury bond market,has increasingly become the focus of attention of both domestic and foreign investors.Since the ‘Bond Connect' between Hong Kong and the mainland bond market went into service in July 2017,overseas institutions have significantly strengthened their investment in Chinese bonds,especially in the areas of government bonds,policy bank bonds,government-backed institution bonds,and NCDs.However,many investors are still exploring their toolbox to hedge against inflation risk when it comes to treasury bonds investment and therefore it is necessary to locate a financial instrument that is closely related to the macro economy,inflation resistant,while enjoying good liquidity.The main purpose of this paper is to analyze the inflation hedging effect of steel futures on treasury bonds.Based on the "Fisher effect" theory,the paper clarifies the relationship between the actual return on assets and the expected inflation rate.First,a systematic research of domestic and foreign relevant theories suggests that China is currently in the stage of structural inflation.The fluctuation of PPI will have a significant impact on industrial organizations' profits and GDP deflator,so more attention should be placed on PPI as a measure of inflation in treasury bonds investment.Studies have shown that commodity futures prices could well reflect the market's expectations of PPI.From the perspective of practical application,since the commodity futures index cannot be traded,this paper uses steel future which enjoys the highest trading volume as a representative.By means of ADF unit root test,cointegration test and Granger causality test,the long-term stable relationship between steel futures price and PPI has been verifiable.And a further cross-correlation test proves that steel futures price is a leading indicator of PPI,thus logically confirming that steel futures can be used as a hedging instrument tradable against Inflation expectations measured as PPI.In addition,based on Fama and Schwert's theory of inflation protection theory,this paper constructs an equation for empirical testing purpose,and uses OLS regression analysis to prove that steel futures can not only provide complete protection against inflation,but also against additional risk resulting from unexpected inflation.According to the above observations,we test retrospectively the performance of a portfolio containing 20% of steel futures and 80% of medium-to long-term treasury bond index,during high-inflations well as low inflation period in real history,proving the effectiveness of steel futures as a good hedge instrument against inflation risk.Finally,we provide further suggestions on possible improvement of investment strategies.