Inflation Derivatives

Inflation derivatives are a type of exotic derivative, which depending on the contract, can give the holder the right, but not the obligation, to receive a payment based on the rate of inflation during a certain period of time. However, many inflation derivatives, such as zero-coupon inflation swaps, are binding forward contracts that impose a strict financial obligation on both counterparties to exchange cash flows. This type of derivative can be used by investors as a hedge against rising prices.

The inflation derivative is an OTC or exchanged-traded derivative that’s used to transfer inflation risk from one entity to another. They are sometimes called inflation-indexed derivatives.

Inflation options also exist. These include things like straddles as well as interest rate caps and interest rate floors.

These options can be priced versus year-on-year swaps. Swaptions (options on swaps) are commonly priced against the zero-coupon yield curve (ZC curve).

Asset swaps are also created where the coupon payments on inflation bonds and the redemption pickup at maturity is exchanged for interest rates payments shown as a premium or discount to a common discount rate (LIBOR was formerly common, but is now being transitioned to SOFR) relevant to the bond coupon period.

Real interest rate swaps are equal to the nominal interest rate swaps minus the relevant inflation swap. Inflation is often referenced as a “breakeven” rate, or the rate between the market pricing of real rates (as inferred from the inflation-linked bond) minus nominal rates (as inferred from the nominal bond pricing).

Inflation derivatives vs. Currency swaps

Inflation derivatives are also tangentially related to the concept of a currency swap, given inflation can impact currency prices and exchange rates.

A currency swap is a type of exotic derivative in which two entities agree to exchange fixed payments in one currency for fixed payments in another currency. This type of swap can be used by businesses who want to protect themselves from fluctuations in currency exchange rates.

This is common for businesses that have liabilities denominated in one currency but assets denominated in another. If the currency their liabilities are denominated in goes up relative to the one their assets are denominated in, this is like the equivalent of an increase in interest rates and/or principal.

Also, by locking in a rate of inflation through an inflation derivative, they can ensure that their expenses will remain relatively stable, regardless of what happens to the exchange rates between the two currencies.