Inflation Derivatives

Inflation Derivatives

Inflation derivatives are a type of exotic derivative, which give the holder the right, but not the obligation, to receive a payment based on the rate of inflation during a certain period of time. This type of derivative can be used by investors as a hedge against rising prices.

The inflation derivative is an OTC or exchanged-traded derivative that’s used to transfer inflation risk from one entity to another. They are sometimes called inflation-indexed derivatives.

Inflation feeds into interest rates (nominal and real rates) so interest rate swaps often are considered a form of inflation derivative.

These might also include swaps on underlying products such as inflation-linked bonds (ILBs). These include products such as:

  • Treasury Inflation Protected Securities (TIPS)
  • UK inflation-linked gilt securities (ILGs)
  • Italian BTPeis
  • French OATeis
  • German Bundeis and
  • Japanese JGBis

Inflation swaps are pure inflation-based derivatives.

Government bonds also react to forces outside inflation, such as real growth and term premium.

Recreating a pure inflation bet in the sovereign debt markets would involve going long the inflation-linked bond and shorting the nominal rate bond of the equivalent tenor.

Inflation swaps can be similar to fixed versus floating interest rate swaps (a derivative form of nominal rate bonds) but use a real rate coupon rather than nominal rate versus floating and also pay a redemption pickup at maturity.

Inflation swaps are often priced on a zero-coupon basis, where payment isn’t exchanged until maturity. One party will pay the compounded fixed rate while the other will pay the inflation rate.

They can also be paid year-on-year where the rate of change of the price index is paid year-on-year. These are often paid yearly in the case of European inflation swaps, but many swaps are paid monthly for the US market. Even if coupons are paid monthly, the inflation rate is still the year-on-year rate, usually CPI (i.e., headline inflation).

Inflation options also exist. These include things like straddles as well as interest rate caps and interest rate floors.

These options can be priced versus year-on-year swaps. Swaptions (options on swaps) are commonly priced against the zero-coupon yield curve (ZC curve).

Asset swaps are also created where the coupon payments on inflation bonds and the redemption pickup at maturity is exchanged for interest rates payments shown as a premium or discount to a common discount rate (LIBOR was formerly common, but is now being transitioned to SOFR) relevant to the bond coupon period.

Real interest rate swaps are equal to the nominal interest rate swaps minus the relevant inflation swap. Inflation is often referenced as a “breakeven” rate, or the rate between the market pricing of real rates (as inferred from the inflation-linked bond) minus nominal rates (as inferred from the nominal bond pricing).

Inflation derivatives vs. Currency swaps

Inflation derivatives are also tangentially related to the concept of a currency swap, given inflation can impact currency prices and exchange rates.

A currency swap is a type of exotic derivative in which two entities agree to exchange fixed payments in one currency for fixed payments in another currency. This type of swap can be used by businesses who want to protect themselves from fluctuations in currency exchange rates.

This is common for businesses that have liabilities denominated in one currency but assets denominated in another. If the currency their liabilities are denominated in goes up relative to the one their assets are denominated in, this is like the equivalent of an increase in interest rates and/or principal.

Also, by locking in a rate of inflation through an inflation derivative, they can ensure that their expenses will remain relatively stable, regardless of what happens to the exchange rates between the two currencies.