What is an inflation swap?
An inflation swap is when two parties trade fixed cash amounts; they trade the risk of inflation from one party to another.
One person in an inflation swap pays a fixed rate of cash flow on a made-up principal amount, and the other person pays a rate that changes based on an inflation measure, like the GDP. The person who pays the floating rate multiplies the nominal capital amount by the rate that considers inflation. The director doesn’t change hands very often. The swap comprises two legs, one for each cash flow.
This is how an inflation swap works:
Professionals in the financial world use inflation swaps to reduce the risk of inflation and make money from price changes. Inflation swaps are helpful for a lot of different types of businesses. People who pay for inflation are usually businesses that get money from inflation as part of their primary business. For example, a utility company could be used because its income is linked to inflation.
In an inflation swap, one party will get a payment that changes based on the inflation rate and pay a set amount of interest. The other party will pay the payment that changes based on the inflation rate and receive the payment that changes based on the fixed interest rate. To figure out the payment sources, nominal amounts are used. Most of the time, zero-coupon swaps happen, meaning the cash flows only change at maturity.
Like other swaps, an inflation swap starts valued at its face value, or “par.” If interest rates and inflation change, the remaining floating payments on the swap will either increase or decrease in value. There are set times when the market value of the swap is found. Depending on the value of the swap, one party will give security to the other party, and the other party will do the same.
Why inflation swaps are a good idea
One good thing about an inflation swap is that it gives an expert a pretty good idea of what the market thinks the “break-even” inflation rate is. In a way, it’s a lot like how the price of any good is set in a market: a buyer and a seller agree to trade at a specific rate. The rate given is the expected inflation rate in this case.
The two people involved in the swap agree on a price based on their different predictions of the inflation rate for the given period. Like interest rate swaps, the parties trade cash flows based on a “notional principal amount,” but they don’t trade this amount. They only trade on the inflation rate instead of protecting themselves against or betting on interest rate risk.
Example of an Inflation Swap
A person who buys business paper is an example of this. The investor also signs an inflation swap contract, giving and getting a fixed rate and a rate that changes based on inflation.
When an investor does an inflation swap, the inflation part of the commercial paper goes from being floating to being set. The investor gets real LIBOR, credit spread, and a floating inflation rate from the commercial paper. They trade this for a set rate with another party.
Conclusion
- Inflation swaps are deals in which one party gives another party the risk of inflation in exchange for a set payment.
- Getting a pretty good idea of the “break-even” inflation rate from an inflation swap is possible.
- Professionals in the financial world use inflation swaps to reduce the risk of inflation and make money from price changes.
