In finance, inflation derivative (or inflation-indexed derivatives) refers to an

over-the-counter Over-the-counter (OTC) drugs are medicines sold directly to a consumer without a requirement for a prescription from a healthcare professional, as opposed to prescription drugs, which may be supplied only to consumers possessing a valid prescr ...

and exchange-traded

derivative In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...

that is used to transfer

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

risk from one counterparty to another. See

Exotic derivatives An exotic derivative, in finance, is a derivative (finance), derivative which is more complex than commonly traded "vanilla" products. This complexity usually relates to determination of payoff; see option style. The category may also include de ...

Derivative

Typically,

real rate swaps Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010 ...

also come under this bracket, such as asset swaps of

inflation-indexed bond Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation or deflation on a daily basis. They are thus designed to hedge the inflation risk of a bond. Th ...

s (government-issued inflation-indexed bonds, such as the

Treasury Inflation Protected Securities United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. gov ...

, UK inflation-linked gilt-edged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and Japanese JGBis are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a

real rate coupon Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010 ...

versus floating, but also pay a

redemption pickup Redemption may refer to: Religion * Redemption (theology), an element of salvation to express deliverance from sin * Redemptive suffering, a Roman Catholic belief that suffering can partially remit punishment for sins if offered to Jesus * P ...

at maturity (i.e., the derivative form of

s). Inflation swaps are typically priced on a zero-coupon basis (ZC) (like

ZCIIS The Zero-Coupon Inflation Swap (ZCIS) is a standard derivative product which payoff depends on the Inflation rate realized over a given period of time. The underlying asset is a single Consumer price index (CPI). It is called ''Zero-Coupon'' bec ...

for example), with payment exchanged at the end of the term. One party pays the

compounded fixed Compound may refer to: Architecture and built environments * Compound (enclosure), a cluster of buildings having a shared purpose, usually inside a fence or wall ** Compound (fortification), a version of the above fortified with defensive stru ...

rate and the other the actual

rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) (like

YYIIS The Year-on-Year Inflation-Indexed Swap (YYIIS) is a standard derivative product over Inflation rate. The underlying is a single Consumer price index (CPI). It is called ''Swap'' because each year there is a swap of a fixed amount against a floa ...

for example) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the

coupons In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product. Customarily, coupons are issued by manufacturers of consumer packaged goods or by retailers, to be used in re ...

are paid monthly, the

inflation rate In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

used is still the year-on-year rate.

Options Option or Options may refer to: Computing *Option key, a key on Apple computer keyboards *Option type, a polymorphic data type in programming languages * Command-line option, an optional parameter to a command *OPTIONS, an HTTP request method ...

on inflation including

interest rate caps An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment f ...

, interest rate floors and

straddle In finance, a straddle strategy involves two transactions in options on the same underlying, with opposite positions. One holds long risk, the other short. As a result, it involves the purchase or sale of particular option derivatives that all ...

s can also be traded. These are typically priced against YOY swaps, whilst the swaption is priced on the ZC curve. Asset swaps also exist where the

coupon payment In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product. Customarily, coupons are issued by manufacturers of consumer packaged goods or by retailers, to be used in ...

of the linker (inflation bond) as well as the

at maturity is exchanged for

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, t ...

payments expressed as a

premium Premium may refer to: Marketing * Premium (marketing), a promotional item that can be received for a small fee when redeeming proofs of purchase that come with or on retail products * Premium segment, high-price brands or services in marketin ...

discount Discount may refer to: Arts and entertainment *Discount (band), punk rock band that formed in Vero Beach, Florida in 1995 and disbanded in 2000 * ''Discount'' (film), French comedy-drama film * "Discounts" (song), 2020 single by American rapper Cu ...

LIBOR The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...

for the relevant

bond coupon Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemic ...

period, all dates are co-terminus. The

is the above par redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The proceeds notional equals the

dirty nominal price Dirt is an unclean matter, especially when in contact with a person's clothes, skin, or possessions. In such cases, they are said to become dirty. Common types of dirt include: * Debris: scattered pieces of waste or remains * Dust: a gener ...

of the bond at the time of purchase and is used as the

fixed notional Fixed may refer to: * ''Fixed'' (EP), EP by Nine Inch Nails * ''Fixed'', an upcoming 2D adult animated film directed by Genndy Tartakovsky * Fixed (typeface), a collection of monospace bitmap fonts that is distributed with the X Window System * F ...

on the

leg.

Real rate swaps Real may refer to: Currencies * Brazilian real (R$) * Central American Republic real * Mexican real * Portuguese real * Spanish real * Spanish colonial real Music Albums * ''Real'' (L'Arc-en-Ciel album) (2000) * ''Real'' (Bright album) (2010 ...

are the

nominal interest swap rate Nominal may refer to: Linguistics and grammar * Nominal (linguistics), one of the parts of speech * Nominal, the adjectival form of " noun", as in "nominal agreement" (= "noun agreement") * Nominal sentence, a sentence without a finite verb * ...

less the corresponding inflation swap. As for modelling, the trend has been either to provide : * a model describing at the same time, nominal rates, real rates and inflation and representing the inflation as the exchange rate between nominal and real rates. The first type of model along these lines has been the one of Jarrow and Yildirim. * a market model that represents the inflation like a real asset and uses similar ideas as the one of BGM to represent the inflation returns. The first type of model along these lines has been the one of Belgrade, Benhamou, Koehler that is commercially available in Pricing Partners modelling suite. Another more advanced version has been the one of Fabio Mercurio and Nicola Morenihttp://www.fabiomercurio.it/stochinf.pdf, Pricing Inflation Indexed options with stochastic volatility, Fabio Mercurio, Nicola Moreni, August 2005

References

External links

ISDA Inflation Derivatives DefinitionsHughston; "Inflation Derivatives"Jarrow & Yildirim; "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model" Journal of Financial and Quantitative Analysis, Vol. 38, No. 2, June 2003Huang & Cairns; "Valuation and Hedging of LPI Liabilities"Hoare Capital Markets LLP
{{Derivatives market Derivatives (finance) Interest rates Inflation

Derivative

References

Further reading

External links