Inflation Swaps

By definition inflation swaps make use of either inflation-indexed derivatives or inflation derivatives in order to transfer the risk of inflation from one party to another. They have actually become quite popular within the past decade within pension funds because of the need to match inflation assets with future liabilities. The derivatives in the swaps may be exchange traded or over-the-counter (OTC) derivatives and at times both types are used within a single fund. While some swaps are made to speculate on price changes, inflation swaps are solely to hedge inflation risk. There are actually three main types of inflation swaps which are zero coupon inflation swaps, annual inflation swap and inflation income swaps.

Zero Coupon Inflation Swap
Sometimes a zero coupon inflation swap is referred to as an Interbank inflation swap. This particular type of inflation swaps sees the cash flow exchange on the maturity date. The exact value of any cumulative inflation on a fixed sum is paid for the predetermined time period. Most often this is the choice preferred by investors, especially in pension funds, because investments need to be complaint with long-term obligations that are inflation related.

Annual Inflation Swap
Annual inflation swaps, commonly referred to as year-on-year, are most commonly seen in Europe where the inflation is used on a yearly bases rather than the cumulative inflation used in other types of swaps. Most often inflation swaps are priced on payments being exchanged at maturity, or zero-coupon. In the United States, payments are most often made on a month-to-month basis. In either case, there are two legs to the swap whereby on party agrees to pay the compound fixed rate while the other leg pays the inflation rate for the specified term of the swap. The difference between the European variation and that of the U.S. is that in Europe the annual rate of change within the price index is paid annually while in the U.S. payment is made monthly even though the annual rate is used.

Inflation Income Swaps
In this type of inflation swap, there are two cash flows exchanged, both following an inflation index. While one party (leg) pays a fixed inflation increase once a year over the term of the contract the other leg pays the actual inflation over that same time period. An inflation income swap actually involves a succession of zero-coupon swaps.

Advantages of Inflation Swaps
Depending on which side of the fence you are sitting on, inflation can work for or against you. Take for example governments, corporations dealing in utilities or real estate ventures that actually benefit from inflation because of the higher profits inflation brings along with it. On the other side of the fence there are pension funds, insurers and even private investors who make out much better when inflation is low in order not to face a margin that is shrinking. Because of this, the main advantage of inflation swaps is having the ability to hedge against price rises in the future which is the synonymous with rising prices. In other words the main advantage is to protect future income from inflation.

Unfortunately, there are disadvantages as well. The key disadvantage of inflation swaps is when inflation rates change drastically over the term of the contract. Losses of this nature can expose both legs (parties) to negative equity (loss of profit). Even so, as governments around the globe work wholeheartedly to staunch the rise of inflation to keep their economies under control, inflation swaps continue to be a favorite investment in a portfolio. It is therefore safe to say that when economies start to be exposed to out of control inflation, inflation swaps will become much less popular.

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