Inflation Index-Linked Swaps
Introduction
Inflation can be defined as a general increase in the price of goods and services over a period of time.
where P and 
are price levels and resultant inflation rates at the indexed time points.
Inflation swaps, unlike inflation indexed bonds, can be used to create customized trades to take positions on the inflation itself. Inflation swaps are used by financial professionals to mitigate the risk of inflation and to use the price fluctuations to their advantage, for example:
- Risk transfer
- Increased liquidity
- Cash flow customization
- Hybrid structure creation
A clear bottleneck in trading inflation swaps in the past has been the liquidity constraints when initiating or unwinding positions in customized deals.
Like other swaps, at the outset, an inflations swap values at par. As interest and inflation rates change, the value of the swap's outstanding payments will change to be either positive or negative. From time to time, the market value of the swap is calculated. A counterparty will post collateral to the other party and vice versa depending on the value of the swap.
FINCAD provides functions for valuing Zero-coupon and Year-on-Year inflation swaps and for building inflation curves from Zero-coupon swap rates.
Technical Details
Year-on-Year Swaps
These swaps have annual cash flows where one party (the inflation seller) pays:
And the other party (the inflation buyer) pays:
where
Zero-coupon Swaps
These swaps have a single cash flow at maturity where one party (the inflation seller) pays:
And the other party (the inflation buyer) pays:
where
Inflation Curve
This curve is built from a series of zero-coupon swap rates. These rates directly give the expected value of the index on each maturity date (minus indexation lag). If is the zero-coupon swap rate for maturity m, then:
Analysis Supported
FINCAD inflation index-linked swap functions can be used for the following:
- Calculates an inflation curve, given a set of zero-coupon inflation swap rates.
- Calculates the fair value and expected cash flow for a Zero Coupon inflation swap.
- Calculates cash flows for a Year-on-Year inflation swap
- Calculates price and par rate for a Year-on-Year inflation swap
To evaluate the FINCAD solutions to value various inflation swaps, contact a FINCAD Representative.