May 9, 2011
Q & A
If US Treasury bonds are not risk-free due to inflation risk, does it make sense to diversify a portfolio of government bonds with obligations of other countries?
EFF/KRF: Inflation does not have much volatility over short-term periods, for example, two years or less, so for short-term bonds there is little benefit from international diversification to lower inflation risks. For intermediate and long-term portfolios, international diversification to lower inflation risk makes sense if the portfolio is hedged against short-term changes in exchange rates. The hedge is helpful because purchasing power parity does not hold; that is, exchange rates vary more than can be explained by changes in the price levels in countries. With purchasing power parity, hedging the exchange rate would be unnecessary.
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ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R.
McCormick Distinguished
Service Professor of
Finance at the University
of Chicago Booth School
of Business
Kenneth R. French
The Carl E. and Catherine
M. Heidt Professor of
Finance at the Tuck
School of Business at
Dartmouth College
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Dimensional Fund Advisors Ltd. is authorised and regulated in the United Kingdom by the Financial Services Authority (FRN: 150100), is registered in England and Wales under Company No. 02569601 and VAT No. 577327607. The registered office address of Dimensional Fund Advisors Ltd. is 7 Down Street, London, W1J 7AJ, United Kingdom. Dimensional Fund Advisors Ltd. is a subsidiary of Dimensional Fund Advisors.