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Wednesday, June 20, 2018

Primer: Inflation Swaps

An inflation swap is a derivative contract that corresponds to breakeven inflation. The advantage of an inflation swap for analysis is that it does give a pure read on an economic breakeven inflation rate, as the contract literally implies an economic inflation breakeven. The problem with the inflation swap market – at least when I was working in fixed income – was the limited liquidity for the contracts. In addition, it does not represent a cash investment, and so is not accessible to some investors, while for others, it does not fit into how they view portfolio construction.

This article is an unedited excerpt of my upcoming book on inflation breakeven analysis. There are numerous references to other sections of the book, which I have left in place. The book is largely completed, but I am holding off publication until August or September.

Once again, this text only covers the general structure of inflation swaps. There are technical details that vary depending upon the market, but those details are distraction from the basic principles involved.

The standard (“vanilla”) inflation swap contract is a zero-coupon arrangement with a fixed leg and an inflation leg to a particular expiry date. The inflation index to be used in the contract is presumably the same one as is used by inflation-linked bonds, but one needs to be careful. I am unsure what the trader lingo is for these swaps, but one party will receive inflation/pay fixed, and the other side pays inflation/receives fixed.

The only cash flows for the swap will be at the expiry date. Each market has a standard calendar rules that will gives an exact date that corresponds to standard tenors such as a “10-year swap.” One can choose other expiry dates, but the non-standard tenor may affect pricing. The main technical detail to the calendar calculation is that the rules are set so that the expiry date is always a working day.

  • The side that receives fixed will receive a cash flow that is equal to the notional value of the contract times a compounding factor. This compounding factor is based on a nominal interest rate that is specified in the swap contract; this fixed rate is the “swap rate” that will be quoted by pricing services. The compounding calculation uses a swap market zero coupon convention that takes into account the working days between the swap settle date and expiry. This amount is exactly known (down to rounding conventions) as soon as the contract is entered into.
  • The side that receives inflation will receive the notional value times the daily index value (using the inflation-linked market calculation rules) of the expiry date divided by the index value of the settle date. The daily index value for the settlement date will be known; only the daily index value at expiry is unknown. That is the only uncertainty in the contract terms at its inception.
  • The actual contract language will specify the payment as a net payment, and not two gross payments. This is to avoid problems in the case of bankruptcy. Breaking the cash flows into two pieces is an analytical convenience, but the fact that it is a net flow matters if analysing counter-party risk.

Figure: Inflation swap flows.
Example. Alex enters into a 2-year inflation swap with Betty, with a swap rate of 2% and a contract notional value of $100. Alex is receiving inflation, Betty pays inflation. Both sides decided to use a simple interest rate convention. The CPI index is 200 at the settle date, and ends up at 205 on the expiry date (approximately 1.24% annualised).

  • Alex receives $100×(205/200) = $102.50.
  • Betty receives $100×(1.02)2 = $104.04.
  • The net cash flow is Alex paying Betty $1.54.

Since the realised annualised inflation rate was below the swap rate, the side receiving inflation (Alex) lost money on the contract.

Unlike bonds, we can build up the equivalent of a yield curve (an inflation curve) just by reading off a grid of inflation swap rates. (Section 2.7 discusses fitting curves based on index-linked bond prices.) If one is comfortable with the data, it would be the easiest source of inflation expectations to work with. However, one might be concerned about the limited liquidity of inflation swaps; it is entirely possible that the inflation swap curve could be off the inflation breakeven curve implied by bonds.

One factor causing a divergence (in some markets) is that some inflation-linked bonds feature a principal put (notably U.S. TIPS; see Section 3.7). If one has access to price quotes for derivatives matching the principal put, one could adjust inflation-linked bond prices to take them into account.

The lack of liquidity is harder to quantify.  Inflation swaps illiquidity is related to the one-sided nature of the inflation-linked market, as will be discussed in Section 4.6. Although textbooks like to imagine “speculators” that determine swap market pricing, we need entities with the balance sheet capacity to act as the counterweight to hedgers. Since there are few entities with a short inflation risk profile, it is difficult to find much balance sheet capacity willing to remain net short inflation. In practice, dealers hold inflation-linked bonds as their hedge against inflation, which means that inflation-paying capacity in the swap market is just re-purposed inflation-linked bonds. However, this is a balance sheet intensive trade, which poses liquidity risks (as seen in 2008). Inflation swap market pricing needs to incorporate a premium to account for this financing risk.

The hedging problems for dealers in inflation-linked swaps are much greater than is the case for standard interest rate swaps. Interest rate swaps are used extensively by issuers of and investors in corporate fixed income securities, as well as relative value versus government bonds. Conversely, inflation swaps are effectively only traded against (central) government inflation-linked debt. Meanwhile, the one-way nature of flows in inflation swaps makes it very difficult for dealers to get out of their arbitrage positions. As a result, I would view bond breakevens as being the benchmark for pricing, with inflation swaps a secondary market. That is, if there is a deviation between the two breakeven inflation rates, the one that matters from a macro perspective is the bond breakeven.

(c) Brian Romanchuk 2018

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