TABLE OF CONTENTS

SAMPLE OF ZERO COUPON INFLATION SWAP.....................................................................................................................12

PERIOD ON PERIOD INFLATION SWAPS.........................................................................................................13
CONCLUSION...........................................................................................................................................................14
REFERENCES............................................................................................................................................................15

TOPIC OF STUDY
Derivative products are perceived to be financial weapons carrying dangers that are
potentially lethal and they usually wreak destruction to a large scale. However, they are also
considered as an indispensable tool for minimizing risk and providing flexibility to its users.
Moreover, sometimes they are even responsible for driving the domestic and global economies.
The derivatives products are divided into several categories with each one of them is unique in
its configuration and proposition. Inflation-related derivatives products are one of its type and
they are gaining widespread popularity all over the world. Considering its cardinal importance in
the global arena, we have selected inflation derivatives as our topic of investigation. We will
describe the significance of inflation derivatives products with laying special importance to its
market. The report will cover the market participants by describing why the buyers and sellers
need inflation derivatives product. Finally, the report aims to discuss few of the models
pertaining to inflation-linked derivatives which are used in the contemporary arena.

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 SCOPE
Considering the fact that inflation derivative is a vast topic by itself therefore we will
restrict ourselves in describing two models which include zero coupon inflation swaps and
period-by-period inflation swaps. In addition to that since derivative has not yet set its footstep in
Pakistani market therefore we will use the international standards for explaining our topic.
Finally, due to some unwieldy constraints, like time limitations and our naiveness in this field;
our research might not encompass an important nugget of information which again reduces the
scope of this research.

RESEARCH METHODOLOGY
This study will be a purely qualitative research aiming to understand the inflation
derivatives market, its operations and two inflation-linked derivatives models. We will only
conduct a literature review of the topic and use internet, journals, and books as a source of
information to capture facts and figures.

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 INTRODUCTION
In recent years the market for inflation-linked derivative securities has experienced
considerable growth. From almost non-existent in early 2001, it has grown to about €50bn
notional traded through the broker market in 2004, which was actually twice the notional traded
through the broker market in 2003 (Kerkhof, 2005). Rapid growth in this avenue of derivatives is
expected to continue for the coming years of the financial markets. So far the growth has mainly
been driven by the European market, but recently interest rates in the US market have picked up
as well which attracted financial specialists towards inflation linked derivates.
Derivatives are mostly the game of transferring the various risks exposures to a willing
counterparty. Extending upon this, therefore the primary purpose of inflation derivatives is the
transfer of (unknown) inflation risk so that the entity can have a known charge to pay against that
and can have smooth operations with pre-determined figures. For example, real estate companies
may want to shed some of their natural exposure to inflation risk, while pension funds may want
to cover their natural liabilities to this risk. In their simplest form, inflation derivatives provide
an efficient way to transfer inflation risk. But their flexibility also allows them to replicate in
derivative form the inflation risks embedded in other instruments such as standard cash
instruments (that is, inflation-linked bonds). As is the case for the nominal interest rate market,
the advantage of inflation derivative contracts over inflation bonds is that derivatives, as it is
implicit to them, can be tailored to fit particular client’s demand more precisely by a customized
package as opposed to the bonds.
With the introduction of unfunded inflation-linked products, inflation derivatives have for
the first time separated the issue of funding from inflation risk. This has made inflation markets
more accessible to parties with high funding costs and made it cheaper to leverage inflation risk.
For instance, hedge funds are increasingly involved in inflation markets. Before any participant
enters the inflation derivatives market, a clear and comprehensive understanding of all the
associated mechanics, risks and valuation of inflation derivatives is essential and we will
describe them in detail.

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 THE MARKETS
Growth and size
The inflation derivatives market has grown from an almost non-existent and fairly exotic branch
of the interest rate market to a sizeable market with substantial growth potential. European
governments have been issuing inflation-indexed bonds since the beginning of the 80’s, but it is
only in the very last years that these bonds, and inflation-indexed derivatives in general, have
become more and more popular (Mercurio, 2005). The pace of this growth has been swift. This
is evidenced by inter-dealer data on notional volumes traded (Figure 1). Volume doubled in 2004
to about €50bn from about €25bn in 2003 (Kerkhof, 2005). The rapid pace of this growth in the
past few years is partly attributable to the favorable macroeconomic environment.
Figure 1 (Source: Inflation Derivatives Explained, Lehman
Brothers)

Market participants
Inflation products attract a diverse group of investors such as banks, pension funds,
mutual funds, insurance companies and hedge funds. Banks want to receive inflation on swaps to
hedge inflation-linked retail products that they offer to the clients. Whereas, Insurance
companies and pension funds want to receive inflation to match their long-term inflation-linked
liabilities. Figure 2 illustrates how the market participants operate in inflation- linked
derivatives’ market. We will now attempt to discuss individually some of the natural payers and
receivers and their incentives to carry out the deal.

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Inflation payers
Payers of inflation are entities that receive inflation cash flows in their natural line of
business. Typical examples are sovereigns and utility companies. As their income is linked
(either explicitly or implicitly) to inflation, they are ideally suited to pay inflation in the inflation
market. Following is a list of several reasons for issuing inflation-linked debt.

1. For market participants with an income stream explicitly or implicitly linked to inflation,
inflation-linked securities are actually a natural hedge instrument against variations in inflation
rates, making them attractive for the purpose the entity’s asset-liability management.

2. Investors are interested in real returns rather than nominal returns. Inflation-linked bonds
guarantee a real return, whereas nominal bonds guarantee a certain nominal, but uncertain real
return. In order to compensate investors for taking the inflation risk accompanied with nominal
bonds, nominal yields should be sufficiently high that the expected real return on nominal bonds
is greater than the guaranteed real return on inflation-linked bonds. This additional yield on the
nominal bonds is called the inflation risk premium. By issuing inflation-linked debt the issuer
can thus save the inflation risk premium (or part of it).

3. In periods of shortage, inflation payers may prefer to pay low initial cash flows making up for
this with higher payments later on. As inflation is typically positive, inflation-linked bonds fit
such a cash flow structure.

4. Another reason for issuing inflation-linked debt is to attract an investor base that is interested
in the potential diversification benefits offered by these securities.

Inflation receivers
Inflation receivers are typically entities that need to pay inflation-linked cash flows in
their natural line of business. Examples include pension funds and insurance companies (e.g. via
selling additional pension coverage policies). As their liabilities are linked (either explicitly or
implicitly) to inflation, they are ideally suited to receive inflation in the inflation market. For
instance, as pension funds need to minimize their shortfall risk with as low as possible pension

5
premiums, they would be having a natural interest in inflation-linked securities to match their
inflation-linked liabilities accruing over the period of time. Having inflation paying securities on
their asset side can substantially reduce their shortfall risk as the value of their inflation-linked
assets increases and simultaneously decreases in relation with their liabilities. The same holds for
insurance companies selling inflation-linked additional pension coverage policies. Therefore,
typically these institutions receive inflation in the inflation market.
Another important group of inflation receivers is the retail investment market. Although
most people invest in inflation-linked cash flows via their pension schemes, many investors
prefer to additionally invest directly in inflation-linked securities.

Other players
Besides investors who are drawn to inflation markets in their natural line of business,
inflation markets can offer attractive features for “inflation-neutral” investors. As inflation risk is
not separately traded or is traded as a combination of other risks, it should provide diversification
benefits for any investor. Furthermore, attractive relative value opportunities can arise for
inflation-neutral investors.

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 Figure 2

INFLATION INDICES
All inflation-linked products need a measuring index of inflation against which we price
the inflation linked amount to serve as the base for the t+tenor inflation rate for the purpose of
determining the inflation linked future cashflow. These are known as inflation. In this section we
will describe the inflation indices used in the most important inflation markets.
Euro area
The euro area inflation swap market is currently by far the most liquid, active and
transparent inflation swap market. The benchmark index for the euro area is the non-seasonally
adjusted Euro HICPxT (Harmonized Index of Consumer Prices excluding Tobacco) published by
Euro statistics. Consumption levels of the 12 different countries are used to weight the index. As
countries accede to the monetary union, they will be included in the index. It is typically
published two weeks after the end of the month. For instance, the Euro HICPxT index value for
March is announced on about 15 April. The index announced is called the unrevised index.
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Eurostat might revise the index if after gathering more data they feel their initial announcement
was inaccurate.
Although the value of the index can be revised, the unrevised version is used in both the
cash and the derivatives market. Eurostat publishes the Euro HICPxT index to the OATEI01
page on Reuters and the CPTFEMU<Index> on Bloomberg. The major constituents of the index
are given in Figure 3. The base year for HICPxT is 1996, meaning that the average index value
of HICPxT equaled a 100 during 1996.

Figure 3 (Source: Inflation Derivatives Explained, Lehman

United States
Brothers)
Although the US inflation market has the largest backing of inflation-linked bond issues,
liquidity remains substantially lower than in the euro-area, French and UK markets. It uses the
same index as the TIPS market, the non-seasonally adjusted US City Average. All Items
Consumer Price Index for all Urban Consumers (CPI-U) published by the Bureau of Labour
Statistics (BLS). The index can be found on Bloomberg, CPURNSA<Index>. The base is given
by the average index of 1982-1984. The constituents of the US CPI are presented in Figure 4

8
Figure 4 (Source: Inflation Derivatives Explained, Lehman
Brothers)

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 INFLATION CONCEPTUAL THEORY
Inflation, nominal value and real value
Investors are concerned about goods and services that money can buy or the assets that
they can acquire with their funds, and therefore they aren’t concerned about money itself. For
instance, as a general rule of economics, people would prefer a 5% increase in income and no
increase in prices to a doubling of income and doubling of prices, so as to have real increments
in earnings/returns, etc. This simple, but important and fundamental, economic axiom is crucial
to the understanding of inflation-linked markets. Because the (consumer) market consists of a
broad variety of products, a basket of goods and services is constructed that tries to represent the
basket of goods and services used by a representative customer to make a consumer price index
based on the weighted-average prices of the items of that basket of goods.
We assume that all investors are and remain interested in this basket of goods and
services. The nominal value of the basket of goods and services is computed at regular intervals
(typically monthly). An inflation index is nothing more than the relative value of the basket. A
base date is chosen at which the nominal value of the index is set to 100. If the nominal value of
the basket equals Rs. 10,000 at the base date it means that the index will rise 1 point if the basket
value increases by Rs. 100.
One of the key tasks of most governments is to increase the values of the real assets of its
inhabitants. Most governments have legislation in place that also gives employees the right to
inflation-linked compensation to be paid out in their salaries. This is typically achieved by a
salary increase depending on an inflation index at regular intervals (typically, annually). Also
property rental prices are often linked to an inflation index, meaning that the property owners
may increase rents according to the rise in the inflation index at pre-specified intervals.

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 INFLATION DERIVATIVE MODELS
Zero Coupon Inflation Swaps
The most regularly traded structure in the inflation-linked swaps market, and particularly
in the inter-dealer market, is the zero coupon inflation swap. The zero-coupon inflation swap has
become the standard inflation derivative. For many, it is the basic building block of the inflation
derivatives market. Its appeal is its simplicity and the fact that it offers investors and hedgers a
wide range of possibilities that did not previously exist in the cash market.
In its definition, a zero-coupon inflation swap is basically a bilateral contract that enables
an investor or hedger to secure an inflation-protected return with respect to an inflation index.
The inflation buyer (also called the inflation receiver) pays a predetermined fixed rate, and in
return receives from the inflation seller (also called the inflation payer) inflation-linked payment.
If the value of the index in the base month is known at the time of the inception of the contract,
we call the inflation swap spot starting. If the value of the index in the base month is not yet
known, we speak of a forward starting inflation swap. There are no exchanges until the maturity
of the swap, or in other words it is a zero coupon transaction.

Figure 5

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.
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Sample of Zero Coupon Inflation Swap

Figure 6

Term 5 years

Fixed rate 11%

Floating CPI

Notional PKR 1,000,000

Payment Frequency Zero Coupon

Solution
Inflation indext 2009 100

Inflation indext 2014 185

Table 1
Fixed value 685058.1551
In Inflated value 850000
the above
Differential value 164941.8449
example the
Pension fund is supposed to hedge its inflation-linked liabilities which it has to pay after the
period of five years. It pays a fixed rate of 11% to the counterparty while receiving inflation-
linked cash flow after five years. Since it is found that the inflated value exceeds fixed value
therefore the counterparty pays the differential amount to the Pension fund at the end of the
tenor.

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 PERIOD ON PERIOD INFLATION SWAPS
A period-on-period (p-o-p) inflation swap has multiple payments during its life.
However, instead of paying the cumulative inflation from the start date up to the coupon dates, it
pays the inflation over a number of accrual periods. The most common structure is the year-on-
year (y-o-y) inflation swap, which pays annual inflation at the end of each year. The year-on-
year structure involves one counterparty agreeing to receive an annual coupon determined by the
Y/Y rate of inflation in return for paying a fixed rate. It is a pay-as-you-go feature and the
inflation payout is the ‘published’ inflation figure for the year. It is of interest to cash-flow
customers, and is fashionable as a deposit for retail products with regular return (Elhederey,
2003). In the US, Y/Y Inflation swaps tend to be quoted in the monthly cash flow format,
whereas in Europe the cash flow frequency will tend to be annual (Barclays Capital 2005).

Notional x dayfrac x
(fixedrate)

Counter Counter
Party A Party B

Notional x dayfrac x (()-1)

Figure 6

Here is a typical example of period to period inflation swap with coupon every six months over
the notional amount of Rs. 50,000.

Figure 7

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 CONCLUSION
The inflation market has experienced exponential growth over the last couple of years,
and the number of participating investors is growing by the day. Pension funds and other
inflation receivers have brought a new powerful impulse to this market. The challenge for the
future is to increase liquidity even more and create flexible structured solutions that fit the
specific needs of different participants; eventually it is the diversity of the inflation market that
will allow it to compete with the very established interest rate market.

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 REFERENCES
Barclays Capital 2005, Inflation Derivatives A User’s Guide, Available from
<http://www.classiccmp.org/transputer/finengineer/%5BBarclays%5D%20Inflation
%20Derivatives%20.pdf>
Elhedery, Georges 2005, Inflation toolbox: New Products and Developments, Available from
<www.scribd.com/doc/6735303/Inflation-Swaps>
Kerkhof, Jeroen 2005, Inflation Derivatives Explained Markets, Products, and Pricing,
Available from <www.classiccmp.org/.../%5BLehman%20Brothers,%20Kerkhof%5D
%20Inflation%20Derivatives%20Explained.pdf>
Mercurio, Fabio 2003, Pricing Inflation-Indexed Derivatives, Available from
<www.fabiomercurio.it/Inflation.pdf>

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