Zero-Coupon Inflation Swap (ZCIS)
What Is a Zero-Coupon Inflation Swap (ZCIS)?
A zero-coupon inflation swap (ZCIS) is a type of derivative in which a fixed-rate payment on a notional amount is exchanged for a payment at the rate of inflation. An exchange of cash flows permits investors to either reduce or increase their exposure to the changes in the purchasing power of money.
A ZCIS is in some cases known as a breakeven inflation swap.
Understanding a Zero-Coupon Inflation Swap (ZCIS)
A 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 a ZCIS, which is a fundamental type of inflation derivative, an income stream tied to the rate of inflation is exchanged for an income stream with a fixed interest rate. A zero-coupon security doesn't make periodic interest payments during the life of the investment. All things considered, a lump sum is paid on the maturity date to the holder of the security.
Similarly, with a ZCIS, both income streams are paid as one lump-sum payment when the swap arrives at maturity and the inflation level is known. The payoff at maturity relies upon the inflation rate realized over a given period of time, as estimated by an inflation index. In effect, the ZCIS is a bilateral contract used to give a hedge against inflation.
While payment is commonly exchanged toward the finish of the swap term, a buyer might decide to sell the swap on the over-the-counter (OTC) market prior to maturity.
Under a ZCIS, the inflation receiver, or buyer, pays a predetermined fixed rate and, in return, gets an inflation-linked payment from the inflation payer, or seller. The side of the contract that pays a fixed rate is alluded to as the fixed leg, while the flip side of the derivatives contract is the inflation leg. The fixed-rate is called the breakeven swap rate.
The payments from the two legs capture the difference among expected and real inflation. On the off chance that genuine inflation surpasses expected inflation, the subsequent positive return to the buyer is considered a capital gain. As inflation rises, the buyer procures more; in the event that inflation falls, the buyer acquires less.
Computing the Price of a Zero-Coupon Inflation Swap (ZCIS)
The inflation buyer pays a fixed amount, known as the fixed leg. This is:
Fixed Leg = A * [(1 + r)t - 1]
The inflation seller pays an amount given by the change in the inflation index, known as the inflation leg. This is:
Inflation Leg = A * [(IE \u00f7 ~~IS) - 1]
where:
- A = Reference notional of the swap
- r = The fixed rate
- t = The number of years
- IE = Inflation index toward the end (maturity) date
- IS = Inflation index toward the beginning date
Illustration of a Zero-Coupon Inflation Swap (ZCIS)
Assume that two gatherings go into a five-year ZCIS with a notional amount of $100 million, a 2.4% fixed rate, and the agreed-upon inflation index, for example, the Consumer Price Index (CPI), at 2.0% when the swap is agreed upon. At maturity, the inflation index is at 2.5%.
Fixed Leg = $100,000,000 * [(1.024)5 - 1)] = $100,000,000 * [1.1258999 - 1]
= $12,589,990.68
Inflation Leg = $100,000,000 * [(0.025 \u00f7 0.020) - 1] = $100,000,000 * [1.25 - 1]
= $25,000,000.00
Since the accumulated inflation rate increased above 2.4%, the inflation buyer benefitted; otherwise, the inflation seller would have benefitted.
Special Considerations
The currency of the swap determines the price index that is utilized to compute the rate of inflation. For instance, a swap named in U.S. dollars would be founded on the CPI, a proxy for inflation that measures price changes in a basket of goods and services in the United States. A swap named in British pounds, in the mean time, would normally be founded on Great Britain's Retail Price Index (RPI).
Like each debt contract, a ZCIS is subject to the risk of default from either party, either due to transitory liquidity issues or more critical structural issues, like insolvency. To moderate this risk, the two players might consent to put up collateral for the amount due.
Other financial instruments that can be utilized to hedge against inflation risk are real yield inflation swaps, price index inflation swaps, Treasury Inflation-Protected Securities (TIPS), municipal and corporate inflation-linked securities, inflation-linked certificates of deposit, and inflation-linked savings bonds.
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, specifically the agreement between a buyer and a seller (among demand and supply), to execute at a predefined rate. In this case, the predetermined rate is the expected rate of inflation.
Basically, the two gatherings to the swap come to an agreement in light of their separate 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 gatherings exchange cash flows in view of a notional principal amount (this amount isn't really exchanged), yet rather than hedging against or conjecturing on interest rate risk, their emphasis is exclusively on the inflation rate.
Features
- As inflation rises, the inflation buyer gets more from the inflation seller than what they paid.
- With a ZCIS, both income streams are paid as a single lump sum when the swap arrives at maturity and the inflation level is known, rather than trading periodic payments.
- Alternately, on the off chance that inflation falls, the inflation buyer gets less from the inflation seller than what they paid.
- A zero-coupon inflation swap (ZCIS) is a type of inflation derivative, where an income stream that is tied to the rate of inflation is exchanged for an income stream with a fixed interest rate.
