Inflation-Linked Korea Treasury Bonds as a Strategic Asset

Abstract

The Korean government introduced its first inflation indexed bond, the Inflation-Linked Korea Treasury Bond (hereafter KTBi), in March 2007. This paper investigates the role of KTBi as a strategic asset in a nominal asset portfolio by estimating a bivariate GARCH model with conditional correlation and by conducting spanning tests. Estimation of the bivariate GARCH model reveals that market information such as the yield curve slope and yield spread between KTBi and KTB are useful in predicting the correlation between the returns of KTBi and KTB as well as the level of the returns of these two assets. Unconditional and conditional spanning tests produce different results regarding the potential role of KTBi as a strategic asset. While unconditional spanning tests do not reject the null hypothesis that existing assets span KTBi, the same null hypothesis is strongly rejected by conditional spanning tests. Such a result means that KTBi is capable of improving the mean-variance efficiency when added to existing investment portfolios.