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 reduct ...

risk from one counterparty to another. See

Exotic derivatives An exotic derivative, in finance, is a 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 derivatives with a non- ...

Derivative

Typically, real rate swaps also come under this bracket, such as

asset swap In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...

s 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, UK inflation-linked

gilt-edged securities Gilt-edged securities are bonds issued by the UK Government. The term is of British origin, and then referred to the debt securities issued by the Bank of England on behalf of His Majesty's Treasury, whose paper certificates had a gilt (or gil ...

(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 In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations wit ...

(which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity (i.e., the derivative form of

s). Inflation swaps are typically priced on a zero-coupon basis (ZC) (like ZCIIS for example), with payment exchanged at the end of the term. One party pays the compounded fixed 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 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 r ...

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 on inflation including interest rate caps, 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 A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps. Types of ...

is priced on the ZC curve. Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup 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, ...

payments expressed as a premium or discount to

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 period, all dates are co-terminus. The redemption pickup 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

. The proceeds notional equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the

leg. Real rate swaps are the nominal interest swap rate 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