Primer: Inflation Swaps

An inflation swap is a derivative contract that corresponds to breakeven inflation. The wages of an inflation swap for analysis is that it does laissez passer on a pure read on an economical breakeven inflation rate, every bit the contract literally implies an economical inflation breakeven. The occupation alongside the inflation swap marketplace – at to the lowest degree when I was working inward fixed income – was the express liquidity for the contracts. In addition, it does non stand upwardly for a cash investment, as well as then is non accessible to some investors, spell for others, it does non fit into how they sentiment portfolio construction.

This article is an unedited excerpt of my upcoming mass on inflation breakeven analysis. There are numerous references to other sections of the book, which I create got left inward place. The mass is largely completed, but I am belongings off publication until August or September.

Once again, this text only covers the full general construction of inflation swaps. There are technical details that vary depending upon the market, but those details are distraction from the basic principles involved.

The measure (“vanilla”) inflation swap contract is a zero-coupon organisation alongside a fixed leg as well as an inflation leg to a special death date. The inflation index to endure used inward the contract is presumably the same ane every bit is used past times inflation-linked bonds, but ane needs to endure careful. I am unsure what the trader lingo is for these swaps, but ane political party volition have inflation/pay fixed, as well as the other side pays inflation/receives fixed.

The only cash flows for the swap volition endure at the death date. Each marketplace has a measure calendar rules that volition gives an exact appointment that corresponds to measure tenors such every bit a “10-year swap.” One tin conduct other death dates, but the non-standard tenor may impact pricing. The principal technical special to the calendar calculation is that the rules are laid then that the death appointment is ever a working day.

• The side that receives fixed volition have a cash menstruum that is equal to the notional value of the contract times a compounding factor. This compounding element is based on a nominal involvement charge per unit of measurement that is specified inward the swap contract; this fixed charge per unit of measurement is the “swap rate” that volition endure quoted past times pricing services. The compounding calculation uses a swap marketplace null coupon convention that takes into draw of piece of work organisation human relationship the working days betwixt the swap settle appointment as well as expiry. This amount is just known (down to rounding conventions) every bit before long every bit the contract is entered into.
• The side that receives inflation volition have the notional value times the daily index value (using the inflation-linked marketplace calculation rules) of the death appointment divided past times the index value of the settle date. The daily index value for the village appointment volition endure known; only the daily index value at death is unknown. That is the only dubiousness inward the contract terms at its inception.
• The actual contract linguistic communication volition specify the payment every bit a cyberspace payment, as well as non 2 gross payments. This is to avoid problems inward the representative of bankruptcy. Breaking the cash flows into 2 pieces is an analytical convenience, but the fact that it is a cyberspace menstruum matters if analysing counter-party risk.

Example. Alex enters into a 2-year inflation swap alongside Betty, alongside a swap charge per unit of measurement of 2% as well as a contract notional value of $100. Alex is receiving inflation, Betty pays inflation. Both sides decided to exercise a uncomplicated involvement charge per unit of measurement convention. The CPI index is 200 at the settle date, as well as ends upwardly at 205 on the death appointment (approximately 1.24% annualised).

• Alex receives $100×(205/200) = $102.50.
• Betty receives $100×(1.02)2 = $104.04.
• The cyberspace cash menstruum is Alex paying Betty $1.54.

Since the realised annualised inflation charge per unit of measurement was below the swap rate, the side receiving inflation (Alex) lost coin on the contract.

Unlike bonds, nosotros tin build upwardly the equivalent of a yield flexure (an inflation curve) merely past times reading off a grid of inflation swap rates. (Section 2.7 discusses plumbing equipment curves based on index-linked bond prices.) If ane is comfortable alongside the data, it would endure the easiest source of inflation expectations to locomote with. However, ane mightiness endure concerned close the express liquidity of inflation swaps; it is solely possible that the inflation swap flexure could endure off the inflation breakeven flexure implied past times bonds.

One element causing a divergence (in some markets) is that some inflation-linked bonds characteristic a principal set (notably USA TIPS; meet Section 3.7). If ane has access to cost quotes for derivatives matching the principal put, ane could accommodate inflation-linked bond prices to accept them into account.

The lack of liquidity is harder to quantify.  Inflation swaps illiquidity is related to the one-sided nature of the inflation-linked market, every bit volition endure discussed inward Section 4.6. Although textbooks similar to imagine “speculators” that determine swap marketplace pricing, nosotros ask entities alongside the residue canvas capacity to human activity every bit the counterweight to hedgers. Since at that spot are few entities alongside a brusk inflation run a endangerment profile, it is hard to honour much residue canvas capacity willing to stay cyberspace brusk inflation. In practice, dealers concord inflation-linked bonds every bit their hedge against inflation, which agency that inflation-paying capacity inward the swap marketplace is merely re-purposed inflation-linked bonds. However, this is a residue canvas intensive trade, which poses liquidity risks (as seen inward 2008). Inflation swap marketplace pricing needs to comprise a premium to draw of piece of work organisation human relationship for this financing risk.

The hedging problems for dealers inward inflation-linked swaps are much greater than is the representative for measure involvement charge per unit of measurement swaps. Interest charge per unit of measurement swaps are used extensively past times issuers of as well as investors inward corporate fixed income securities, also every bit relative value versus regime bonds. Conversely, inflation swaps are effectively only traded against (central) regime inflation-linked debt. Meanwhile, the one-way nature of flows inward inflation swaps makes it real hard for dealers to locomote out of their arbitrage positions. As a result, I would sentiment bond breakevens every bit beingness the benchmark for pricing, alongside inflation swaps a secondary market. That is, if at that spot is a difference betwixt the 2 breakeven inflation rates, the ane that matters from a macro perspective is the bond breakeven.

(c) Brian Romanchuk 2018