I have a situation where I have to give a fixed price to a customer over 7 years. How can I hedge inflation (as defined by wage growth) with financial products over this time period. Notional would be about 3MM.
I don't see how you can without taking on more risk than you would have with no hedge. I think you just need to make some assumptions and price them in.
There are pitfalls of hedging to lock in a fixed price over a period of time. What if costs drop over the 7 years, will your customer expect a lower price also? A few years ago a natural gas company in my area was trying to compete with the major gas company (BC Hydro) by buying natural gas futures and locking in a price for its customers - natural gas then dropped significantly and the customers went to the media crying about how the lower cost of natural gas wasn't being passed on to them.
TIPS, probably, is the closest you can get... You might need to do something about oil/gasoline, though.
How clean are TIPS? They're tied to CPI and according to JPM only have a correlation of ~.36 to CPI from '05-'12. Historical labor compensation has increased at an average annual rate of ~2-3% depending on the area of manufacturing, according to the BLS: http://www.bls.gov/news.release/archives/prin_03272014.htm Rather than trying to tie specifically to wage growth you could find the least risky way to generate 2-3% pa. The Barclays Aggregate Bond Index (AGG is an ETF) should be able to deliver that with minimal vol and risk of loss on principal. The MTM vol is real but risk of loss on principal over a 7yr cycle should be very little and should generate a positive return even if wage growth declines. It may not be the most capital efficient choice. ...since '09 correlation btwn payrolls growth and consumer spending has been almost one for one...you could always buy Apple!
Yikes. Any CPI based solution will leave you terribly under hedged to wage growth. That's how "The Man" designed it. Just give him an honest Corp Fin answer (unless it costs you your job) and tell him he needs to go big on operating leverage instead. FYI. You might want to call the CME research department. They probably have some research/proposals for such a product. They have for almost everything under the sun.
I would have to buy tips and sell treasuries to isolate the CPI component, right? Is there a basis to that that would create signiciant noise?
Yes long tips short treasuries....afaik the right structure is to trade zeroes to minimize any duration/rate mismatch. Could also sell puts for the rate hedge if you have a view.
I read somewhere that long-term ETF bonds reflected in such funds as the iShares 20+ Year Treasury Bond ETF (TLT ) or the iShares 7-10 Year Treasury Bond ETF (IEF) have a negative correlation to monthly inflation. In other words, you can expect to lose capital because of price declines and have the real value of your portfolio be eroded by inflation too. But I don’t know how you could correlate that with wages over that timeframe?...
Yes, that's right, this is a "breakeven inflation" trade. As to the "basis", yes, there's always a component of breakeven inflation which is driven by liquidity etc, rather than underlying inflation. However, that shouldn't be too painful in this case. Given the ease of using ETFs, I'd imagine you can do this breakeven trade reasonably easily. If I am not mistaken, there should be a treasury ETF out there whose duration matches that of the Barclays TIPS index (should be arnd 7 years). I dunno if I would just go long treasuries outright, as a way of generating the 2 - 3% pa return. If things change and US, for whatever reason, goes through a period of decent wage growth/inflation, your "hedge" might end up hurting, rather than helping.