Understanding and Using Inflation Swaps

Checklist
This checklist explains what an inflation swap is and why it is used.

Definition
An inflation swap involves the use of inflation derivatives (or inflation-indexed derivatives) to transfer
inflation risk from one party to another. The derivatives used may be over-the-counter or exchange-traded
derivatives. Inflation swaps have become increasingly popular since the turn of the century as pension
funds, for example, recognize the need for inflation-linked assets that match future liabilities. Conversely,
borrowers such as governments or large corporations understand that inflation-linked assets or revenues can
be funded by inflation-linked debt. Inflation swaps frequently include real rate swaps, such as asset swaps of
inflation-indexed bonds. Inflation swaps are simply a linear form of such derivatives. Real rate swaps consist
of the nominal interest swap rate minus the corresponding inflation swap.
There are three main types of inflation swap. In a standard interbank inflation-linked swap, or zero-coupon
inflation-linked swap, cash flow is exchanged on the maturity date. This swap pays out the exact value of
the cumulative inflation for a fixed capital sum over a determined period. This is a good option for investors,
particularly pension funds, seeking an investment mix aimed at compliance with long-term, inflation-related
obligations.
In a year-on-year inflation-linked swap, inflation is used on an annual basis rather than a cumulative one.
This structure is suitable for investors seeking to protect cash flow. Typically, an inflation swap is priced on
a zero-coupon basis, with payment exchanged upon maturity. One party pays the compound fixed rate,
while the other pays the actual inflation rate for the term of the swap. In Europe, inflation swaps are typically
paid on a year-on-year basis where the year-on-year rate of change of the price index is paid. In the United
States, payment is more typically on a month-on-month basis, although the inflation rate used is still the
year-on-year rate.
In an inflation-linked income swap two cash flows are exchanged, each of which follows the inflation index.
One party pays a fixed inflation increase annually over the period of the contract. The other party pays the
actual inflation over the period of the contract. The swap itself consists of a series of zero-coupon swaps.
Other traded inflation derivatives include caps, floors, and straddles, which are usually priced against year-
on-year swaps. The inflation derivatives market in the United Kingdom is substantial, although the equivalent
market in the eurozone is many times bigger.

Advantages
Public authorities, and companies dealing in utilities, real estate, and distribution all benefit from high inflation
as it brings bigger profits. Conversely, insurers, pension funds, and private investors fare better when
inflation is low, as otherwise they face a shrinking margin. Thus, there is a potential market for selling or
buying inflation. The key advantage of entering into an inflation swap is being able to hedge against future
price rises or diminishing margins. By selling inflation in an inflation-linked swap, future income linked to
inflation can be protected.

Disadvantages
The main disadvantage of participating in an inflation swap is the risk that inflation rates may change
drastically as a result of unexpected shifts in the global economy. Such changes can expose parties to loss
of profit or negative equity.

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More Info
Books:
• Brice, Benaben (ed). Inflation-linked Products: A Guide for Investors and Asset & Liability Managers.
London: Risk Books, 2005.
• Brigo, Damiano, and Fabio Mercurio. Interest Rate Models—Theory and Practice, with Smile, Inflation
and Credit. Corrected 3rd printing. Berlin: Springer, 2007.
• Deacon, Mark, Andrew Derry, and Dariush Mirfendereski. Inflation-indexed Securities: Bonds, Swap &
Other Derivatives. 2nd ed. Wiley Finance Series. Chichester, UK: Wiley, 2004.
• Hull, John C. Options, Futures, and Other Derivatives. 7th ed. Prentice Hall Series in Finance. Upper
Saddle River, NJ: Prentice Hall, 2008.
• Redhead, Keith. Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps.
London: Prentice Hall, 1996.
• Walmsley, Julian. The Foreign Exchange and Money Markets Guide. 2nd ed. Wiley Frontiers in
Finance Series. New York: Wiley, 2000.

Website:
• Website dedicated to the topic of inflation derivatives: www.inflationderivatives.com

See Also
Best Practice
• A Total Balance Sheet Approach to Financial Risk
Checklists
• Derivatives Markets: Their Structure and Function
• Methods for Dealing with Inflation Risk
• Swaps, Options, and Futures: What They Are and Their Function
Finance Library
• Futures, Options, and Swaps

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