Inflation derivatives
Encyclopedia
In finance
, inflation derivative (or inflation-indexed derivatives) refers to an over-the-counter
and exchange-traded derivative
that is used to transfer inflation
risk from one counterparty to another. Typically, real rate swaps
also come under this bracket, such as asset swap
s of inflation-indexed bond
s (government-issued inflation-indexed bonds, such as the Treasury Inflation Protected Securities, UK inflation-linked gilt-edged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and Japanese JGBis are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating
, but also pay a redemption pickup at maturity
(i.e., the derivative form of inflation indexed bonds).
Inflation swaps are typically priced on a zero-coupon basis (ZC) (like ZCIIS for example), with payment exchanged at the end of the term. One party pays the compounded fixed rate and the other the actual inflation
rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) (like YYIIS for example) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate
used is still the year-on-year rate.
Options
on inflation including interest rate caps
, interest rate floors
and straddle
s can also be traded. These are typically priced against YOY swaps, whilst the swaption
is priced on the ZC curve.
Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at maturity
is exchanged for interest rate
payments expressed as a premium
or discount to LIBOR for the relevant bond coupon period, all dates are co-terminus. The redemption pickup is the above par
redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional
in the case of the proceeds asset swap
. The proceeds notional
equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the LIBOR leg.
Real rate swaps are the nominal interest swap rate less the corresponding inflation swap.
Print
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, inflation derivative (or inflation-indexed derivatives) refers to an over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
and exchange-traded derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
that is used to transfer inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
risk from one counterparty to another. Typically, real rate swaps
Interest rate swap
An interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
also come under this bracket, such as asset swap
Asset swap
An asset swap is an exchange of tangible assets for intangible assets or vice versa. Since it is a swap of assets, the procedure takes place on the active side of the balance sheet and has no impact on the latter in regards to volume...
s of inflation-indexed bond
Inflation-indexed bond
Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...
s (government-issued inflation-indexed bonds, such as the Treasury Inflation Protected Securities, UK inflation-linked gilt-edged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and Japanese JGBis are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating
Public float
The float of a company whose stock is publicly traded has different default meanings depending on the presumed context.Without a qualifier it may refer to the entire market capitalization of the company or only its publicly traded equity....
, but also pay a redemption pickup at maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
(i.e., the derivative form of inflation indexed bonds).
Inflation swaps are typically priced on a zero-coupon basis (ZC) (like ZCIIS for example), with payment exchanged at the end of the term. One party pays the compounded fixed rate and the other the actual inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) (like YYIIS for example) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate
Inflation rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index . It is the percentage rate of change in price level over time. The rate of decrease in the purchasing power of money is approximately equal.The inflation rate is used to calculate the real interest...
used is still the year-on-year rate.
Options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
on inflation including interest rate caps
Interest rate cap and floor
An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price...
, interest rate floors
Interest rate cap and floor
An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price...
and straddle
Straddle
In finance, a straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, regardless of the direction of price movement...
s can also be traded. These are typically priced against YOY swaps, whilst the swaption
Swaption
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps....
is priced on the ZC curve.
Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at maturity
Maturity (finance)
In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
is exchanged for interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
payments expressed as a premium
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
or discount to LIBOR for the relevant bond coupon period, all dates are co-terminus. The redemption pickup is the above par
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional
Notional
Notional is an American Thoroughbred racehorse. He was sired by In Excess and out of the mare Truly Blessed. His damsire, French Deputy, is a son of the 1997/98 Leading sire in North America, Deputy Minister....
in the case of the proceeds asset swap
Asset swap
An asset swap is an exchange of tangible assets for intangible assets or vice versa. Since it is a swap of assets, the procedure takes place on the active side of the balance sheet and has no impact on the latter in regards to volume...
. The proceeds notional
Notional
Notional is an American Thoroughbred racehorse. He was sired by In Excess and out of the mare Truly Blessed. His damsire, French Deputy, is a son of the 1997/98 Leading sire in North America, Deputy Minister....
equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the LIBOR leg.
Real rate swaps are the nominal interest swap rate less the corresponding inflation swap.
External links
- ISDA Inflation Derivatives Definitions
- Hughston; "Inflation Derivatives"
- Jarrow & Yildirim; "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model" Journal of Financial and Quantitative Analysis, Vol. 38, No. 2, June 2003
- Huang & Cairns; "Valuation and Hedging of LPI Liabilities"
- Hoare Capital Markets LLP
- "Savvysoft prices inflation derivatives
- Brice Benaben; "Inflation-Linked Products: A Guide for Asset and Liability Managers" Risk Books, 2005. ISBN 1-904-33960-3.
- Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; Inflation-Indexed Securities: Bonds, Swaps, and Other Derivatives (2nd edition, 2004) Wiley Finance. ISBN 0-470-86812-0.
- Brigo, Damiano and Fabio Mercurio; "Interest Rate Models -- Theory and Practice, with Smile, Inflation, and Credit" (2nd edition, 2006) Springer Finance. ISBN 3-540-22149-2.