Inflation Swap
What Is an Inflation Swap?
An inflation swap is a contract used to transfer inflation risk starting with one party then onto the next through an exchange of fixed cash flows.
In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, for example, the Consumer Price Index (CPI). The party paying the floating rate pays the inflation-adjusted rate increased by the notional principal amount. Normally, the principal doesn't change hands. Each cash flow includes one leg of the swap.
How an Inflation Swap Works
Inflation swaps are utilized by financial experts to moderate (hedge) the risk of inflation and to utilize the price vacillations to their advantage. Many types of institutions view inflation swaps as significant instruments. Payers of inflation are normally institutions that receive inflation cash flows as their core line of business. A genuine model may be a service company in light of the fact that its pay is linked (either expressly or verifiably) to inflation.
One party to an inflation swap will receive a variable (floating) payment linked to an inflation rate and pay an amount in light of a fixed rate of interest, while the other party will pay that inflation rate linked payment and receive the fixed interest rate payment. Notional amounts are utilized to compute the payment streams. Zero-coupon swaps are generally common, where the cash flows are swapped exclusively at maturity.
Likewise with different swaps, an inflation swap initially values at par, or face value. As interest and inflation rates change, the value of the swap's outstanding floating payments will change to be either positive or negative. At foreordained times, the market value of the swap is calculated. A counterparty will post collateral to the next party and vice versa, contingent upon the value of the swap.
Benefits of Inflation Swaps
The advantage of an inflation swap is that it furnishes an analyst with a genuinely accurate assessment of what the market views as the "earn back the original investment" inflation rate. Reasonably, it is basically the same as the way that a market sets the price for any commodity, in particular the agreement between a buyer and a seller (among demand and supply) to execute at a predefined rate. In this case, the predefined rate is the expected rate of inflation.
Basically, the two parties to the swap come to an agreement in light of their particular takes on what the inflation rate is probably going to be for the period of time being referred to. As with interest rate swaps, the parties exchange cash flows in light of a notional principal amount (this amount isn't really exchanged), however rather than hedging against or conjecturing on interest rate risk, their emphasis is exclusively on the inflation rate.
Inflation Swap Example
An illustration of an inflation swap would be an investor purchasing commercial paper. Simultaneously, the investor goes into an inflation swap contract, getting a fixed rate and paying a floating rate linked to inflation.
By going into an inflation swap, the investor actually turns the inflation part of the commercial paper from floating to fixed. The commercial paper gives the investor real LIBOR plus credit spread and a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.
Features
- An inflation swap can give a really accurate assessment of what might be viewed as the "equal the initial investment" inflation rate.
- Inflation swaps are utilized by financial experts to alleviate (or hedge) the risk of inflation and to utilize the price changes to their advantage.
- An inflation swap is a transaction where one party transfers inflation risk to a counterparty in exchange for a fixed payment.
