Inflation derivatives

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In finance, inflation derivatives (or inflation-indexed derivatives) refer to over-the-counter and exchange-traded derivatives that are used to transfer inflation risk from one counterparty to another. Typically, real rate swaps also come under this bracket, such as asset swaps of inflation indexed bonds (commonly referred to as Treasury Inflation Protected Securities, TIPS, and/or inflation linked fixed income). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity (i.e., the derivative form of inflation indexed bonds).

Inflation swaps are typically priced on a zero-coupon basis (ZC), with payment exchanged at the end of the term. One party pays the compounded fixed and the other the actual inflation rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate used is still the year-on-year rate.

Options on inflation, including caps, floors and straddles, can also be traded. These are typically priced against YOY swaps, whilst the swaption is priced on the ZC curve.

Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at maturity is exchanged for interest rate payments expressed as a premium or discount to LIBOR for the relevant bond coupon period, all dates are co-terminus. The redemption pickup is the above par redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The proceeds notional equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the LIBOR leg.

Real rate swaps are the nominal interest swap rate less the corresponding inflation swap.

[edit] External links

[edit] Print

  • Brice Benaben; "Inflation-Linked Products: A Guide for Asset and Liability Managers" Risk Books, 2005. ISBN 1-904-33960-3.
  • Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; Inflation-Indexed Securities: Bonds, Swaps, and Other Derivatives (2nd edition, 2004) Wiley Finance. ISBN 0-470-86812-0.
  • Brigo, Damiano and Fabio Mercurio; "Interest Rate Models -- Theory and Practice, with Smile, Inflation, and Credit" (2nd edition, 2006) Springer Finance. ISBN 3-540-22149-2.
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