What it means
A swap is an agreement between two parties to exchange payments. In a zero-coupon inflation swap, one side agrees to pay a fixed rate, compounded over the term.
The other side agrees to pay the actual increase in a price index, such as consumer prices, over the same period. Nothing is paid until maturity, which is why it is called zero-coupon.
At that point, the two amounts are netted, and only the difference is paid. The party that expected inflation to be higher gains if inflation exceeds the fixed rate.
Businesses use these contracts to manage inflation risk. A utility whose revenues rise with inflation, for example, may want to swap into fixed payments to stabilise its income.
An insurer or pension fund with payments linked to inflation may want to receive inflation payments so its assets move with its liabilities. The fixed rate agreed on day one is the market's expectation of inflation over the term, often called the breakeven inflation rate.
It is set so the swap has no value at the start. Banks quote these rates, and analysts watch them as a guide to what the market expects.
The nuance is basis risk, which is the chance that the index used in the swap differs from the inflation the business actually faces. If a company's costs are driven by wages and energy, but the swap tracks a broad consumer price index, the hedge may not match perfectly.
The contract also exposes each side to the credit risk of the other. Valuation changes as expectations move.
If the market's expected inflation rises after the swap is agreed, the party receiving inflation sees a gain, and the party paying it sees a loss. Many dealers therefore ask for collateral, meaning cash or securities posted to cover the current value of the swap, which cuts the credit risk on a long contract.
In practice
Real-world examples.
Example
A pension fund owes inflation-linked payments to retirees and enters a swap to receive inflation. When inflation runs high, the swap pays out and offsets the higher cost of its liabilities. The scheme manager reports the hedge ratio to the trustees.
Example
A water company with regulated revenues linked to inflation enters a swap to pay inflation and receive fixed. This stabilises its cash flows so it can service debt at known levels. The treasurer matches the swap's dates to its loan repayments.
Example
An asset manager believes the market is underpricing inflation. It pays the fixed rate and receives actual inflation, expecting to profit if prices rise faster than the market expects. It sizes the position to a limit approved by the risk committee. The manager reviews the value of the swap each month and sets a loss limit at which the position will be closed.
Formula
Calculation
Fixed payment = Notional x [(1 + fixed rate) raised to the number of years - 1]
Inflation payment = Notional x [(Index at end / Index at start) - 1]
A swap has a notional of $10,000,000, runs for 5 years and has a fixed rate of 2.5%. The factor 1.025 raised to the fifth power is about 1.1314, so the fixed payment is 10,000,000 x 0.1314 = $1,314,000. The price index rises from 300 to 336, so the inflation payment is 10,000,000 x (336 / 300 - 1) = 10,000,000 x 0.12 = $1,200,000. The fixed-rate payer pays 1,314,000 and receives 1,200,000, so it pays a net $114,000.Case study
Seen in the real world.
Brightwater Utilities is an illustrative, fictional company whose allowed revenues rise with inflation, but whose debt payments are fixed. The finance director worries that low inflation will squeeze her coverage ratio. She enters a 10-year zero-coupon inflation swap with a $50,000,000 notional.
Brightwater pays inflation and receives a fixed compounded rate of 2.5%. If inflation turns out lower than 2.5%, the swap pays Brightwater, offsetting the shortfall in revenue. If inflation is higher, Brightwater pays out, but its revenue is higher too.
In the illustrative outcome, inflation averages 1.5%, so the swap pays Brightwater a substantial sum at maturity. The finance director chose certainty over the chance of gains, and the lender noted the improved stability of cash flows.
Watch out
Common mistakes.
- Assuming cash is exchanged each year, when a zero-coupon swap settles only once at maturity.
- Ignoring basis risk, when the index in the swap may not match the inflation the business really faces.
- Overlooking counterparty risk, when a large settlement at maturity depends on the other party being able to pay.
Questions
People also ask.
What is the fixed rate in the swap?
It is the market's breakeven inflation rate for that term, set so the swap has no value at the start.
Who uses inflation swaps?
Pension funds, insurers, utilities, infrastructure owners and investors with views on inflation.
Is it the same as an inflation-linked bond?
No, a swap is a derivative contract with no principal exchanged, while an inflation-linked bond is a loan with payments linked to an index.
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