The most regularly traded structure in the inflation-linked swaps market, and particularly in the inter-dealer market, is the zero coupon inflation swap. One counterparty agrees to pay the cumulative percentage increase in the price index over the tenor of the swap (with some lag on the reference index, similar to cash securities), and the other pays a compounded fixed rate. There are no exchanges until the maturity of the swap, or in other words it is a zero coupon transaction.
Inflation Leg = Notional * I(t2)/I(t1) – 1 Cpty A -> B
Fixed Leg = Notional * {(1 + B)^(t2-t1) -} Cpty B -> A
The inflation leg is subject to a lag, and for most markets this is similar to that of the associated inflation-linked bond market. For example, the final value of the inflation leg of a Euro HICPx zero swap maturing on 1 September is going to be the notional value multiplied by the Euro HICPx index value for June divided by the base index value, which is the index value for the month three months prior to the start date of the swap. As it is only the final and the initial index values that determine the value of the inflation leg, which might be thought of as the floating leg, there is no path dependency to cloud the market’s implied inflation expectation given by the fixed rate, or breakeven. If the fixed leg on a 2yr swap is trading at 2.10% it can be said that the market expects the inflation from the base reference index to the final reference index, 24 months later, to precisely equal 2.1% on an annualised basis. This might seem obvious but this simplicity does not strictly hold for bond breakevens, which can be deflected away from fundamental inflation expectations by near-term carry fluctuations, and the extent to which duration differs from the maturity. For the final value of a zero swap it does not matter whether the rise in the inflation index to a given level occurs entirely in the first six-months or occurs gradually over the full tenor. The fixed rate of the swap is therefore a pure breakeven inflation rate, and therefore a cleaner representation of inflation expectations than can be gleaned from the inflationlinked bond markets. The purity of the structure is one of the reasons it has become the benchmark structure. It offers the most flexibility of use, and provides the building blocks for the pricing of other structures and products. For example, the real coupon structure shown in the examples at the end of this section is simply a collection of zeros of equal notional size and with a common base index.
>> If the fixed leg on a 2yr swap is trading at 2.10% it can be said that the market expects the inflation from the base reference index to the final reference index, 24 months later, to precisely equal 2.1% on an annualised basis.
I have one question: what is the compounding convention behind the quoted rate of 2.1%. Annual, semi-annual, quarterly. Also does it differs across markets.