An inflation swap is the linear form of an inflation derivative, an over-the-counter and exchange-traded derivatives that is used to transfer inflation risk from one counterparty to another.
There are three main types of inflation swap. In a standard interbank inflation-linked swap, or zero-coupon
inflation-linked swap, cash flow is exchanged on the maturity date. This swap pays out the exact value of
the cumulative inflation for a fixed capital sum over a determined period. This is a good option for investors,
particularly pension funds, seeking an investment mix aimed at compliance with long-term, inflation-related
obligations.
Advantages
Public authorities, and companies dealing in utilities, real estate, and distribution all benefit from high inflation
as it brings bigger profits. Conversely, insurers, pension funds, and private investors fare better when
inflation is low, as otherwise they face a shrinking margin. Thus, there is a potential market for selling or
buying inflation. The key advantage of entering into an inflation swap is being able to hedge against future
price rises or diminishing margins. By selling inflation in an inflation-linked swap, future income linked to
inflation can be protected.
Disadvantages
The main disadvantage of participating in an inflation swap is the risk that inflation rates may change
drastically as a result of unexpected shifts in the global economy. Such changes can expose parties to loss
of profit or negative equity.