The payoff at maturity depends on the inflation rate realized over a given period of time as measured by an inflation index.
In effect, the zero coupon inflation swap is a bilateral contract used to provide a hedge against inflation. Under a zero coupon inflation swap, the inflation receiver or buyer pays a predetermined fixed rate and, in return, receives an inflation-linked payment from the inflation payer or seller. The side of the contract that pays a fixed rate is referred to as the fixed leg, while the other end of the derivatives contract is the inflation leg. The fixed rate is called the breakeven swap rate and depends on the current time and the inflation period. The payments from both legs captures the difference between expected and actual inflation.
If actual inflation exceeds expected inflation, the resulting positive return to the buyer is considered a capital gain. As inflation rises, the buyer earns more; if inflation falls, the buyer earns less. While payment is typically exchanged at the end of the swap term, a buyer may choose to sell the swap on the over-the-counter OTC market prior to maturity. The inflation buyer pays:. If compounded inflation rises above 2.
The currency of the swap determines the price index that is used to calculate the rate of inflation.
For example, a swap denominated in U. Like every debt contract, a zero coupon inflation swap is subject to the risk of default from either party either because of temporary liquidity problems or more significant structural issues, such as insolvency. This document should not be relied on as a substitute for your own independent research or the advice of your professional financial, accounting or other advisors. This information is subject to change without notice. FINCAD assumes no responsibility for any errors in this document or their consequences and reserves the right to make changes to this document without notice.
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Zero-Coupon Inflation-Indexed Swap
Inflation Index-linked Swaps. Input Argument. Price index value as of the base date. Zero-coupon swap rates: Term years 2. Inflation Rate The term can be a whole number, or a half-integer. Interpolation bootstrapping method: Frequency of grid points on inflation curve. Annual 2. Semi-annual 3.
Quarterly 4. Value date. Effective date. Terminating date. Notional principal amount. Fixed rate. Accrual method daycount convention.
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Indexation lag months. Method used for interpolation from the given inflation curve. Discount factor curve: Fair value swap. Baseline index value. Cash flow table: Inflation rate adjustment. Base date for curve.
Zero-coupon swap rates. Monthly seasonal adjustments. Interpolation Bootstrapping method. Frequency of grid points. Accrual method. Baseline index value optional. Index value at maturity if known. Inflation curve. Table 4. Interpolation method inflation curve.
Inflation Index-linked Swaps
Discount factor curve. Table 5. Interpolation method discount factor curve. Uncollateralised interest rate swaps that are those executed bilaterally without a credit support annex CSA in place expose the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded. Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations.
Collateralised interest rate swaps expose the users to collateral risks.
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Depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements. Credit and funding risks still exist for collateralised trades but to a much lesser extent. Due to regulations set out in the Basel III Regulatory Frameworks trading interest rate derivatives commands a capital usage. Dependent upon their specific nature interest rate swaps might command more capital usage and this can deviate with market movements. Thus capital risks are another concern for users. Reputation risks also exist.
The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators. Hedging interest rate swaps can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks. The other, aforementioned risks must be hedged using other systematic processes. The quotation i. This type of fixed rate is often called an internal rate of return IRR due to its familiar calculation.
It is rare that the IRR is not quoted with an annual frequency to simplify the formula and minimise other discrepancies. The market-making of ZCSs is an involved process involving multiple tasks; curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital. The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis.
The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency of market-making in a drive to efficiency and consistency. From Wikipedia, the free encyclopedia. Further information: Henrard Foundations, Evolution and Implementation.