Introduction to derivatives

Inflation swaps
Overview
In this module, you will learn more about inflation swaps.

What are they?

An inflation swap is an agreement to swap a fixed payment for the
actual rate of inflation. One investor pays an agreed fixed rate and
receives the variable (also known as floating) inflation rate. The other
investor receives the fixed rate and pays out the inflation rate.
An inflation swap is a form of derivative. A derivative is a broad term
for an investment whose value depends on the price of an underlying
asset such as a share or index. The derivative itself is nothing more
than a contract between two investors, usually giving the right to buy
or sell the underlying asset in the future.

How are they traded?

Investors receive a quote by contacting an investment bank, rather
than through an exchange. This is known as trading ‘over the
counter’.
When you enter an interest rate swap agreement, it is based on an
agreed amount – also known as a ‘notional’ amount – for a fixed
period of time, which can be as long as 50 years.

Why use inflation swaps?

If investors believe inflation is likely to be lower than the rate quoted
by the investment bank, they want to receive a fixed rate (and pay
the variable rate, which they believe will fall as inflation falls).
Meanwhile, if investors believe inflation will be higher than the
quoted price, they will choose to receive a floating rate (and pay the
fixed rate).
Example of an inflation swap in action
In this example, we go to an investment bank to get a quote for a five
year inflation swap based on the consumer price index (CPI).

The bank provides a

quote for the fixed side of
the swap. We then have
to choose whether to pay
or receive the fixed
amount.

We believe inflation will

average more than 3% so
we decide to pay the 3%
fixed rate and receive the
floating rate, as measured
by CPI.

In this example, we would make a profit if inflation averages more

than 3% over the five-year period: in this event, we pay a fixed rate
of 3% and receive a higher amount.
Settlement of an inflation swap

Most inflation swaps are ‘zero coupon’ derivatives. This simply means
that the fixed rate and inflation accrue over the term of the swap and
the agreement is settled at the end of the term. Let’s go back to our
example.

There is no interest
paid by either party
during the term of
most inflation swaps.

At the end of the term, the notional amounts of the fixed leg and
inflation leg are compared.

In this example,
inflation averaged
higher than the fixed
rate agreed at the
outset of the inflation
swap.

One payment is made to settle the swap.

In this example, the

inflation payer
receives nothing and
pays out to the
inflation receiver.

Breakeven rate
If the inflation rate is the same as the fixed rate on average over the
term of the swap, the two legs will have the same value and the swap
will break even. For this reason, the fixed leg is also called the
breakeven rate.
In practice – a pension scheme example

Pension schemes have liabilities whose values vary with inflation i.e.
the benefits they will eventually pay out to pensioners. An inflation
swap is a way for pension funds to reduce or eliminate the risk of
inflation.

The pension scheme achieves this objective by paying out an agreed

fixed rate and receiving the variable (floating) rate of inflation. This
variable rate should rise as pension payments rise and fall as pension
payments fall, thereby protecting against the impact of inflation.

An inflation swap
helps to guarantee
that the pensions can
be paid by hedging
future inflation.

What happens in a high inflation environment?

Payments to
pensioners rise
quickly but the
scheme receives
more from the
inflation swap to

What happens in a low inflation environment?

Payments rise more

slowly and the
scheme will receive
less from the
inflation swap.
Test your knowledge
1. How long is the term of the longest inflation swaps traded in the
OTC market?
A. Five years
B. Ten years
C. Thirty years
D. Fifty years

2. Which of the following indices might be used for the floating leg of
an inflation swap?
A. CPI (Consumer Price Index)
B. LIBOR
C. FTSE 100
D. Official base rates

3. Trustees of a pension fund are concerned about how inflation will

affect their ability to meet their pension liabilities. How might they
hedge their exposure?
A. Receive inflation on an inflation swap
B. Pay inflation on an inflation swap
C. Receive the break even fixed rate on an inflation swap
D. None of the above

4. A zero coupon inflation swap is about to be settled. The fixed rate

and floating inflation rate have been accrued through the life of the
swap as detailed below. Which case flow will take place on
settlement?
Fixed leg (inflation payer): £1,105,000
Floating leg (inflation receiver): £1,012,000
A. Inflation payer pays 1,015,000 Inflation receiver receives
1,012,000
B. Inflation payer receives 1,105,000 Inflation receiver pays
1,012,000
C. Inflation payer receives 3,000 Inflation receiver pays 3,000

D. Inflation payer pays 3,000 Inflation receiver receives 3,000

Test your knowledge – solutions
1. Answer D
Inflation swaps have terms as long as fifty years.
2. Answer A
Consumer Price Index
3. Answer A
The pension fund will need to receive inflation on the swap to match the
costs of providing benefits to its pensioners.
4. Answer C
The difference between the notional amounts is paid when the swap is
settled at the end of its term. In this case, the inflation payer’s notional is
higher and they receive payments from the inflation receiver.
Derivatives Glossary
Word/Phrase Meaning
CPI Consumer Price Index, a measure of
price changes in consumer goods.
Credit Default Swaps (CDS) A type of insurance policy on a
corporate bond.
Credit event Default or other event leading to a
“claim”.
Derivative A financial contract whose value is
based on changes in an underlying
asset/index, such as security or
commodity prices, interest rates,
currency rates or financial indices.
Equitising cash Gaining exposure to a market to a
given value until the cash is invested
Exchange A marketplace for trading shares,
options and futures on stocks, bonds,
commodities and indices.
Floating Variable
Futures Agreement to buy a commodity or
financial asset on a date in the future
at a fixed price.
Gain exposure To invest in an asset/market either
directly or through derivatives.
Gilt Bonds issued by the UK government.
Go long (went long) ‘Long’ position - one that will benefit
from the value of the underlying
assets going up.
Go short (went short) ‘Short’ position - one that will benefit
from the value of the underlying
assets going down.
Hedging/hedge away/hedge The purchase or sale of a derivative
(such as options or futures) to reduce,
or eliminate, the risk of holding
another security.
Inflation swaps An agreement to swap a fixed
percentage for the realised inflation
rate as a percentage.
Interest rate swap Agreement to exchange interest rate
payments for a specific period on a
given principal amount. The most
common interest rate swap is a fixed-
for-floating coupon swap.
Itraxx A family of credit default swaps
indices. There are European, American
and Asian indices as well as indices
that focus on particular sectors.
LIBOR The London Inter-Bank Offered Rate,
the interest rate banks use as a
reference when lending to each other.
Notional Agreed/Given amount
Options (also call option/put option) Gives the holder the right to buy/sell
an underlying asset by a certain date
at a fixed price.

Call option: the right to buy shares at

 an agreed price at a future date.

Put option: the right to sell shares at

an agreed price at a future date.
Over-the-counter (OTC) trade A transaction not conducted over an
exchange. For example, securities not
listed on a stock exchange can be
traded through broker-dealers who
communicate by telephone and
computer networks.
Par / par value The nominal, or face, value.
Premium The market price a buyer pays for an
option.
Reference entity The bond issuer.
Reference obligation The specific bond.
RPI Retail Price Index, a measure of price
changes in goods and services.
Segregated fund A fund designed specifically for the
management of an individual pension
scheme.
Spread (between the bid and the offer) The difference between the buy (bid)
and sell (offer) price.
Straddle The simultaneous purchase/sale of
both call and put options for an
underlying asset/index with the same
exercise price and expiration date.
Strike prices The price specified in the option
contract at which the option holder
may buy or sell the underlying
asset/index.
Swaps A contractual agreement where two
parties agree to exchange (swap)
either single payment or a series of
payments in the future. The most
widely used swaps are contracts
relating to interest rates, inflation, or
currencies.
Terms Agreed/Given time