What it means
Many organisations have costs or income that depend on inflation. A pension fund must pay benefits that rise with prices, while a utility might receive revenue that increases with an inflation index.
If actual inflation turns out higher than expected, one side loses and the other gains. The simplest form is the zero coupon inflation swap.
One party agrees to pay a fixed rate, compounded over the life of the contract, and the other agrees to pay the actual percentage rise in a price index, such as a consumer price index, over the same period. At the end only the net difference changes hands.
The fixed rate agreed at the start is called the breakeven inflation rate. It reflects what the market expects inflation to average over the period, plus or minus a premium for the risk.
If actual inflation ends above that rate, the party receiving inflation gains, and if it ends below, the party paying inflation gains. Institutions use the swaps in practice.
A pension scheme with liabilities that rise with inflation may receive inflation payments to hedge its obligations. A company that sells a product with revenue tied to an index may pay inflation and receive fixed, to match its cost base.
There are risks to remember. The counterparty might fail to pay, the index used may not match the exposure exactly, and the contract can show large gains or losses before it ends.
Many contracts therefore include collateral, which is cash or securities posted to cover possible losses. Pricing follows the market for inflation-linked bonds and ordinary bonds.
Banks quote swap rates for standard maturities, and the rate they quote moves as expectations of inflation change.
In practice
Real-world examples.
Example
A pension fund has promised to raise benefits each year in line with prices. It enters a 10-year swap to receive inflation and pay a fixed rate. If prices rise faster than expected, the swap payments help cover the higher benefits. The fund pays no cash upfront, but it must post collateral if the swap loses value.
Example
A property company leases buildings under contracts where rent is fixed for five years. It worries that costs will rise faster than rent, so it receives inflation and pays fixed on a swap. This reduces the gap between rising costs and fixed income. Its lenders view the hedge favourably.
Example
A bank trader sees that the market-implied inflation rate is much lower than her own forecast. She receives inflation on a swap, hoping to profit if prices rise faster. The trade could lose money if inflation turns out low. She sets a limit on the loss she is willing to accept.
Formula
Calculation
Net payment = Notional x [(Index end / Index start) - 1] - Notional x [(1 + Fixed rate)^years - 1]
Suppose a zero coupon swap has a notional (the reference amount) of $10,000,000, runs for 3 years and has a fixed rate of 2%. The fixed leg is 10,000,000 x (1.02^3 - 1) = 10,000,000 x 0.061208 = $612,080.
The price index rises from 250 to 265, a rise of 15 / 250 = 6%, so the inflation leg is 10,000,000 x 0.06 = $600,000. The inflation receiver gets $600,000 and pays $612,080, so it makes a net payment of $12,080. If the index had risen to 270, a rise of 8%, the inflation leg would be $800,000 and the receiver would gain $187,920.Case study
Seen in the real world.
Harbour Retirement Fund is a fictional pension scheme with $200,000,000 of liabilities that grow with inflation. Its trustees feared that a surge in prices would leave the fund short.
The fund entered a 5-year zero coupon swap on $50,000,000, receiving inflation and paying a fixed 2.5%. The fixed leg after 5 years would be 50,000,000 x (1.025^5 - 1) = about $6,570,000.
In this illustrative case, prices rose 15% over the period, so the inflation leg was 50,000,000 x 0.15 = $7,500,000, and the fund gained about $930,000 on the swap. That amount offset part of the extra benefits paid, though the trustees noted that they would have lost money had inflation turned out lower than 2.5% a year.
Watch out
Common mistakes.
- Believing a swap removes all inflation risk, when the index and the timing may not match the actual exposure.
- Ignoring counterparty risk, which is the chance that the other side cannot pay and which is why collateral agreements matter.
- Confusing the breakeven rate with a forecast, when it also includes a risk premium.
Questions
People also ask.
What is a zero coupon inflation swap?
It is a swap where only one payment is made at the end, equal to the difference between the fixed leg and the inflation leg.
Who uses inflation swaps?
Pension funds, insurers, banks, utilities and property companies use them to hedge or to take a view on inflation.
How is the fixed rate set?
It is agreed at the start and reflects the market's expectation of average inflation over the term, plus or minus a premium.
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