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description, tags
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| Buy or sell inflation swaps to exchange fixed and floating (CPI-linked) cash flows, hedging against unexpected inflation or speculating on inflation relative to the breakeven rate. |
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Inflation Hedging — Inflation Swaps
Section: 14.1 | Asset Class: Miscellaneous (Inflation Derivatives) | Type: Hedging / Macro
Overview
Inflation swaps allow parties to exchange a fixed rate of inflation for a floating (CPI-linked) rate, analogous to interest rate swaps. A buyer of an inflation swap is long inflation: they receive the floating CPI-linked rate and pay the fixed rate ("breakeven rate"). The buyer profits if realized inflation exceeds expected inflation (i.e., the fixed swap rate). The fixed rate is typically calculated as the spread between Treasury notes/bonds and TIPS with the same maturity.
Construction / Mechanics
Zero-Coupon Inflation Swap (ZC)
The most common type. Only one cash flow at maturity T (in years). Cash flows per $1 notional:
C_fixed = (1 + K)^T - 1 (500)
C_floating = I(T)/I(0) - 1 (501)
K= fixed rate (the "breakeven rate")I(t)= CPI value at timet;t = 0is when the swap is entered into
Year-on-Year Inflation Swap (YoY)
References annual inflation rather than cumulative. Assuming annual payments (t = 1, ..., T):
C_fixed(t) = K (502)
C_floating(t) = I(t)/I(t-1) - 1 (503)
The buyer pays C_fixed and receives C_floating at each period.
Return Profile
- Buyer (long inflation): profits when realized CPI exceeds the breakeven rate
K; losses when inflation is lower than expected - Seller (short inflation): profits when realized inflation is below
K - Returns are driven by the difference between realized inflation and the fixed swap rate; there is no equity or credit risk in a plain vanilla inflation swap
Key Parameters / Signals
- Breakeven rate
K: the fixed rate embedded in the swap; derived from the Treasury/TIPS spread for the same maturity - CPI index
I(t): typically the Consumer Price Index; contract specifies which index and lag - Maturity
T: ZC swaps concentrate all cash flow at maturity; YoY swaps distribute annual payments - Notional: scales all cash flows linearly
Variations
- Zero-Coupon vs. Year-on-Year: ZC is simpler with one cash flow; YoY resets annually and is less sensitive to base-period CPI distortions
- Real rate swaps: swap fixed real rate for floating real rate; related but distinct instrument
- Inflation caps/floors: options on inflation; cap protects buyer if inflation exceeds a ceiling rate
Notes
- Liquidity in inflation swap markets is concentrated in major currencies (USD, EUR, GBP)
- Counterparty risk: OTC instruments; cleared versions available on some CCPs
- Basis risk between the CPI index in the swap and the actual inflation exposure being hedged
- The fixed rate
Kis model-independent (observed from market), but fair value of the floating leg requires CPI forecasting