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