Inflation Derivatives

Inflation derivatives are also known as inflation-indexed derivatives. According to financial theory, the inflation derivatives are exchange-traded derivatives and over-the-counter derivatives, which are implemented for shifting inflation risk from one party to another party.

Usually, the real rate swaps are also included in inflation derivatives, for example, inflation indexed bond asset swaps (these are generally termed as fixed income linked to inflation and/or TIPS or Treasury Inflation Protected Securities).

The linear forms of inflation derivatives are known as inflation swaps. In some instances, the inflation swaps can obtain an identical form to floating versus fixed interest rate swaps (these are forms of derivatives of fixed rate bonds). However, they implement a floating versus real coupon rate and also a redemption collection at the time of maturity (this refers to the form of derivatives of inflation indexed bonds).

Commonly, the pricing of inflation swaps is done on the basis of zero coupon or ZC and here, the payment is switched over when the term ends. In this process, the fixed compounded rate is paid by one party and the real inflation rate by another party for the term period. The payment of inflation swaps can also be made based on year-on-year. Here the payment of the rate of variation (year-on-year) of price indices is done on a yearly basis similar to the majority of year-on-year swaps in Europe. However, this is done on a monthly basis for a large number of swopped notes in the markets of United States. Although the coupon rates are paid on a monthly basis, the rate of inflation implemented is on the year-on-year basis all the same.

With the help of inflation derivatives, trading of inflation options, which include straddles, floors, and caps may be carried out. Generally, the pricing of these options is done according to the year-on-year swaps and at the same time, the pricing of the swaption is done according to the zero coupon curve.

There is also the existence of asset swaps in those circumstances where the coupon rate paid for the inflation bond or linker is converted for payment of interest rates and it is represented in the form of a discount or premium to London Interbank Offered Rate or LIBOR for the crucial period of bond coupon payment. Every date here is co-terminus.

The actual rate swaps are the forms of nominal interest rate swaps minus the matching inflation swap.

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Last Updated on : 1st July 2013

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