Inflation Derivatives Definition

What are inflation derivatives?

Inflation derivatives are a subclass of derivative contracts used by investors or companies to manage the potential negative impact of rising inflation levels or to speculate on future inflation levels. Like other derivatives, including options or futures, inflation derivatives allow individuals to participate in the price movements of an underlying market or index, in this case, a Consumer price index (CPI).

Key points to remember

  • Inflation derivatives can help investors hedge against the risk that rising levels of inflation will erode the real value of their portfolio.
  • Inflation derivatives allow individuals to participate in the price movements of an underlying market or index, in this case a consumer price index (CPI).
  • While other products like TIPS also offer inflation protection, inflation derivatives like zero coupon swaps are much more versatile and can be more profitable.

Understanding Inflation Derivatives

Inflation derivatives describe a range of strategies from relatively simple swaps to more complex futures and options products. The most common form of an inflation derivative is a inflation swap, which allows an investor to earn an inflation-protected return relative to an index, such as the CPI. The CPI is a measure of the general cost of goods and services in an economy.

In a swap, an investor agrees to pay a consideration a fixed percentage of a notional amount in exchange for a variable rate payment or payments. The variation of inflation during the contract will determine the value of the deposit. The calculation between fixed and floating values ​​is done at predetermined intervals. Depending on the evolution of the compound inflation rate, one party will provide a guarantee to the other party.

Example of Inflation Derivatives: Zero Coupon Inflation Swaps

In the so-called zero-coupon inflation swaps, a one-time payment is made by one party when the contract matures. This single payment contrasts with swaps where the submission of payments occurs throughout the transaction in a series of exchanges.

For example, consider a five-year zero-coupon swap in which Party A agrees to pay a fixed rate of 2.5%, compounded annually, on an amount of $10,000 while Party B agrees to pay the rate of inflation compounded on this principle. If inflation exceeds 2.5%, Party A has come out on top, otherwise Party B makes a profit. In both cases, Party A has skillfully used the swap to transfer its own inflation risk to another individual.

Although inflation swaps are often held to maturity, investors have the option of trading them on the exchange or by over the counter (OTC) before their contract expires. Again, if the rate of inflation on the swap is higher than the fixed rate the investor is paying, the sale will result in a positive return for the investor paying the fixed rate, which is classified by the IRS as a capital gain.

Alternatives derived from inflation

Other inflation hedging strategies include buying Inflation-protected Treasury securities (TIPs) or the use of commodities such as gold and oil which tend to rise with inflation.However, these methods have some disadvantages compared to inflation derivatives, including larger investment minimums, transaction costs and higher volatility. Given their low premium requirements, wide maturity range and low correlation to equities, inflation derivatives have become a mainstream product for investors looking to manage inflation risk. .

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