Inflation Derivatives
What Are Inflation Derivatives?
Inflation derivatives are a subclass of derivatives contracts utilized by investors or firms to deal with the possible negative impact of rising inflation levels or guess on future inflation levels. Like other derivatives including options or futures, inflation derivatives allow individuals to partake in price developments of an underlying market or index, in this case, a Consumer Price Index (CPI).
Figuring out Inflation Derivatives
Inflation derivatives portray a scope of strategies from relatively simple swaps to additional complex futures and options products. The most common form of an inflation derivative is a inflation swap, which allows an investor to secure an inflation-protected return relative to an index, similar to the CPI. The CPI is a measure of the general cost of goods and services in an economy.
In a swap, one investor consents to pay a counterparty a fixed percentage of a notional amount in exchange for a floating rate payment or payments. The change in inflation over the course of the contract will decide the value of the installment. The calculation between the fixed and floating values is at foreordained spans. Contingent upon the shift in the accumulated inflation rate, one party will post collateral to the other party.
Inflation Derivative Example: Zero-Coupon Inflation Swaps
In supposed zero-coupon inflation swaps, a single payment is made by one party at the maturity of the contract. This single-pay differences to swaps where the submission of payments occur all through the deal in a series of exchanges.
For instance, require a five-year zero-coupon swap in which Party A consents to pay a fixed rate of 2.5%, accumulated yearly, on an amount of $10,000 while Party B consents to pay the accumulated rate of inflation on that principle. In the event that inflation dominates 2.5%, Party A has ended up as the winner, on the off chance that not, Party B nets a profit. In either case, Party A has masterfully utilized the swap to transfer their own inflation risk to another individual.
While inflation swaps are many times held through maturity, investors truly do have the option of trading them on exchanges or through over-the-counter (OTC) markets before their contract lapses. Again, in the event that the rate of inflation on the swap is higher than the fixed rate the investor is paying on it, the sale will bring about a positive return for the investor paying the fixed rate, which is classified by the IRS as a capital gain.
Inflation Derivative Alternatives
Other inflation hedging strategies incorporate purchasing Treasury Inflation-Protected Securities (TIPs) or the utilization of commodities, for example, gold and oil that will generally rise with inflation. These methods, nonetheless, do have certain hindrances when compared to inflation derivatives, including bigger investment essentials, transaction fees, and higher volatility. Given their low premium requirements, many maturities, and low correlation to equities, inflation derivatives have turned into a common product for investors hoping to oversee inflation risk.
Features
- Inflation derivatives can help investors hedge against the risk of rising inflation levels eroding the real value of their portfolio.
- Inflation derivatives allow individuals to take part in price developments of an underlying market or index, in this case, a Consumer Price Index (CPI).
- While other products like TIPS additionally offer inflation protection, inflation derivatives, similar to zero-coupon swaps, are considerably more flexible and might be more cost-viable.
