An Inflation Derivative is a subclass of derivative that is used by individuals to mitigate the effects of potentially large levels of inflation. Swaps are the most common types of inflation derivatives, in which a counterparty’s cash flows are linked to a price index and the other counterparty is linked to a conventional fixed or floating cash flow.
In finance, inflation derivative (or inflation-indexed derivatives) refers to an over-the-counter and exchange-traded derivative that is used to transfer inflation risk from one counterparty to another. Typically, real rate swaps also come under this bracket, such as asset swaps of inflation-indexed bonds. 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 versus floating, but also pay a redemption pickup at maturity.
Many investors prefer inflation protection from derivatives because unlike inflation-indexed bonds, a significant amount of capital isn’t required and it’s more flexible. Inflation derivatives require the buyer to provide a small premium to the swap provider. In most cases the Consumer Price Index (CPI) is used measure the differences in annual inflation
Inflation swaps are typically priced on a zero-coupon basis (ZC), with payment exchanged at the end of the term. One party pays the compounded fixed rate and the other the actual inflation rate for the term. Inflation swaps can also be paid on a year-on-year basis (YOY) 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 are paid monthly, the inflation rate used is still the year-on-year rate.
Options on inflation including interest rate caps, interest rate floors and straddles can also be traded. These are typically priced against YOY swaps, whilst the swap ion is priced on the ZC curve.
Real rate swaps are the nominal interest swap rate less the corresponding inflation swap.