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Financial Strategies
Friday, 16 May 2003
Research: Ciaran OHagan (44-20) 7260 1262 cohagan@lehman.com
Borut Miklavcic: (44-20) 7011 7834 bmiklavcic@lehman.com
An Inflation Derivatives Primer: Swaps and Options


A fast-growing market, in $, and .
Inflation swaps are very simple instruments, allowing investors
to take views on inflation/deflation, real rates and diversify
away from fixed-rate bonds. This is often at attractive prices,
as the market tends to have structural biases. Volumes in the
inflation swap market are growing rapidly as more and more
investors, banks, issuers, and corporates discover how this
market can help better manage risk and add to return. Hedge
funds are active as they exploit structural biases in the pricing
of the inflation markets

Monthly Volumes of IL Swaps in Broker Market

Source: ICAP, Lehman Brothers, excluding direct flows

Inflation swaps in a nutshell.
Inflation Swaps allow investors to exchange cash flows linked
to an inflation index against a fixed or variable rate. They are
quoted in terms of breakeven inflation (unlike bonds, quoted in
terms of price and real rates, that is actuarial yield, and where
inflation is only expressed through the net amount paid). We
find that investors often develop a blockage when thinking
about inflation bonds and derivatives. This need not be the
case. In some respects, the pricing of inflation is simpler
than conventional. However this note goes into the subject in
some detail, for the sake of completeness.

Flexibility. Inflation swaps are flexible, a key reason for their
success. The very nature of swaps allows investors structure
transactions according to their own specific requirements,
although there usually are certain conventions as outlined
below. They have several key advantages against OATei or
Made to measure. Inflation swaps can be tailored to
suit the interests of investors. Investors can trade
inflation lag bases. They can also trade certain sectors
such as tobacco or 0% floors.
Off-balance sheet. It is clearly impracticable for
banks to hedge inflation with OATei or TIPs. Even if
two-way liquidity could be found, this imposes a
heavy balance sheet charge. Swaps avoid this.
Size. Volumes in inflation swaps can sometimes be
very large. Unlike in OATi, sizes bigger than 50m,
even a 100m outright, are not uncommon. However
investors that want to do size in inflation often buy at
government bond auctions. In contrast, the swap
market is open for size most days (around bank
holidays is one exception).
Curve. The whole curve is tradable in swaps.
Investors can do maturities out to 10 years. The most
frequently traded maturities are 5-, 7- and 10-year
swaps. The range of maturities allows investors to
even arbitrage the inflation curve.
Liquidity. In comparison to the benchmark inflation
linked bonds, inflation swaps give investors the
benefit of deeper liquidity as well as a broader choice
of maturities. The most liquid tenors can typically
accommodate bid/offer spreads of approximately two
basis points for notionals of up to 100m. The most
liquid tenors with respective bid/offer levels for HICP
ex-tobacco zero coupon swaps are indicated below,
with levels from May 2003:

Maturity Bid Offer
2-year 1.71% 1.73%
5-year 1.78% 1.80%
7-year 1.78% 1.80%
10-year 1.80% 1.82%

Noticeably less liquid
15-year 1.94% 1.96%
25-year 2.11% 2.13%
30-year 2.11% 2.13%

Bid/asks for small sizes may be better on OATei or
TIPs (say under 20m). However sizes transacted in
inflation swaps can be very large as much as several
hundred million euro. This is because inflation swaps
are often used as hedging vehicles for other liabilities.
The best way of working this market is to leave a
reasonable order inside the bid/ask.

Strategy and policy-making. Bond strategists,
economists, central banks and other forecasters
should be keenly interested in swap inflation
breakevens as they provide a very clean way to
estimate inflation expectations. This goes to the very
heart of deciphering risk premia in fixed-income and
deducing which element is driving yields.
May-01 Aug-01 Nov-01 Feb-02 May-02 Aug-02 Nov-02 Feb-03
Lehman Br ot her s | bondMast er An Inf lat ion Derivat ives Primer May 2003, Ciaran OHagan

Characteristics of Inflation Swaps

As in other markets, conventions form the basis for any
inflation-related transaction. Let us explain the standard
conventions used in the inflation swap market, although there
is a certain flexibility in structuring them according to investor

1) Indices

In order to determine cash flows on the inflation leg of the
structure, we first need a commonly agreed measure of

The underlying index for $ and is usually just CPI and RPI.

The underlying index in euro is usually just the eurozone
harmonized index of consumer prices (HICP), as published by
Eurostat. It is an aggregate of the member states HICPs.
Germany and Italy publish towards month-end, followed early
the following month by a flash estimate for HICP, published
by Eurostat. This is the first estimate of the inflation index for
the prior month. The first full estimate is typically published in
the middle of each month. Therefore, the HICP released in say
May, will reflect the level of the index for the month of April.
It is important to note that while the index is subsequently
subject to revisions, it is the initially released unrevised index
(and not the flash) which is usually used for the calculation of
all cash flows. Inflation swaps do not take indexes revisions
into account for simplicity.

A common variant to the HICP traded in the market is the
HICP ex-tobacco. This strips out tobacco prices from reference
index. This particularity only exists in euro, as for abstruse
legal/constitutional reasons, the French government cannot
index against tobacco (this is not the reflection of a view on
tobacco inflation on the part of the AFT).

2) Yield Conventions

Investors directly trade the breakeven rate of inflation.
At the time of writing, this is 1.75% for a 10-year swap in
euro, 1.9% in dollar (yes, higher in dollars, surprisingly).
A receiver of a inflation swap profits if the average rate of
inflation is above 1.75%, over the next 10-years. Conversely a
payer needs inflation to be below 1.75%.

Typically transactions are structured as zero coupon trades,
where the inflation seller or payer at maturity
- pays the cumulative observed inflation for the term of
the trade, and
- receives an annually compounded fixed rate.

Floating leg. The determination of the inflation payout on the
floating leg is very simple. It is usually expressed as follows:

Initial Final

HICP Index Initial : typically the index level observed for the
month 3 months prior to the start of the
interest calculation period
HICP Index Final : typically the index level observed for the
month 3 months prior to the end of the
interest calculation period

This is just simply the inflation between the start and the end
of the swap period, paid at maturity and compounded on a zero
coupon basis (annual).

Fixed leg. An inflation buyer pays the breakeven rate of
inflation (again at maturity).

[ ]
FixedRate Notional + 1

Fixed Rate: rate agreed upon at the start of the
n: term of the transaction in number of years

If the breakeven rate of inflation is 1.75%, the fixed leg
formula is then:

where n is the number of years to maturity.

Very simply, if inflation is above 1.75% in this example,
receivers of inflation make money. If it is below 1.75%,
receivers of inflation lose money.

Unlike TIP or OATei bonds, the real rate is not traded
directly. It can however be worked out by simply subtracting
the inflation breakeven from the fixed rate, i.e. 4% less 1.75%
gives a real rate of 2.25%.

3) A year-on-year coupon swap

Alternatively, the above structure could be reformulated to
include annual coupons. In this case the payment definition
would be the following:

Inflation seller (payer) pays:



0 , max
Yeari Yeari

Inflation buyer (receiver) pays:

[ ] FixedRate Notional + 1

In this case, both parties would make their payments annually,
with the inflation seller paying the year-on-year change in
inflation and the buyer paying an annual fixed rate.

Lehman Br ot her s | bondMast er An Inf lat ion Derivat ives Primer May 2003, Ciaran OHagan

The structure shown here also includes a floor (the 0 element
to the right). This ensures that the inflation buyer never pays
on both legs of the trade, even if year-on-year inflation is
negative. The structure is also available without a floor.

4) Comparable Bonds

The inflation swap market generally derives its projected
inflation levels on the basis of existing inflation linked bonds.

In the case of eurozone inflation, at the time of writing, there
are two such bond issues which are sufficiently liquid for
market participants to use as benchmarks. They are:
OATei 3% 25 July 2012 FR0000188013
OATei 3.15% 25 July 2032 FR0000188799

Benchmark bonds in dollars, at the time of writing:
TII 3.375% Jan 2012 US9128277J52
TII 3.375% April 2032 US912810FQ68

Flows in Inflation Swaps

Example: Customers receiving inflation
A commercial bank issues product with inflation liability
to retail. For example, it sells a bond that pays inflation
plus a fixed rate. The term often ranges from 2 to 5 years.
Often an insurer will want to swap its liabilities. It may
have sold an equity call with inflation zero coupon.

Example: Customers paying inflation
Swapping of long-dated cash flows (e.g. lease cash flows on
domestic indices). The best example of course is the AFT, the
French Treasury, who wants to issue long-dated inflation
bonds as its tax revenues are highly correlated with inflation.
Apart from sovereigns, property companies can occasionally
do very large sizes as well.

These two kinds of flows illustrate why the breakeven curve is
flat and the real rate curve is steep: investors want to buy short-
dated inflation bonds. Issuers want to sell long-dated inflation
bonds. These same flows are reflected in swaps. Customers
want to receive inflation short and pay long.

Opportunities in Inflation Swaps

Options. There is regular trading in inflation floors. These are
at 0%, where an investor might have developed exposure.
Banks that sell inflation product to retail may offer a floor
against negative inflation. So they may come back to hedge
this risk.
This in turn now allows investors to protect against deflation,
wanting to sell the unlikely scenario of deflation.
The market has typically been structurally short in the past. So
sellers of floors (expressing the view that there will be
deflation) have in the past been paid more generously. This is
less the case at the time of writing in May 2002.

Tobacco. If the underlying index is HICP, including tobacco,
this will generally raise the breakeven rate by some 8bp (at the
time of writing) compared to swaps ex-tobacco (ex- trades
more frequently among professionals but final demand if much
greater for tobacco-inclusive swaps). Tobacco inflation can be
traded separately. Because OATis and OATeis do not include
tobacco, there is an active market in trading this spread. See
our research note from 2001, Carry try picking Tobacco.
Investors get good carry when they pay tobacco inflation.
Unfortunately, at the time of writing in 2003, this carry trade,
like many others, has been carried away in the desperate hunt
for yield.

Lag basis trades: Playing, for example, March vs April

Trading Inflation Swaps

The market risks between bonds and swaps are very
similar. A common misconception is that buyers of inflation
profit only when inflation goes up. This is often the case, but is
not inevitable.
- Surprisingly deflation can benefit receivers of
inflation. We clearly saw this for example around the
Gulf War of 2003 when real rates fell, reflecting the
risk of lower long term growth, lower expectation for
central bank rates and so on (in addition to fear of
higher inflation form oil prices).
- A rise in inflation should benefit the mark to market
of a receiver of inflation swaps. This will be all the
more the case if seen as permanent and not short term,
although we have also sometimes seen breakevens
move sharply on month-on-month inflation figures.

The market has shown some biases because of positioning.
For example, there are relatively few issuers or payers of
inflation (the biggest are the three main governments - US, UK
and France) along with some agencies (CADES, RFF), some
corporates in dollars and in sterling mainly, and some property

The demand for inflation from investors has been very strong
over the past few years. This has been for many different
reasons - because of a view on inflation or real rates - or some
need to hedge or diversify. An additional key motivation has
been carry: inflation securities often offer attractive running
yields. In early 2003, the market has been chasing yield, and
this has helped inflation securities. This means that inflation is
dear in swaps, particularly at the time of writing. Floors are
clearly too cheap, and here again there is an imbalance in

Lehman Br ot her s | bondMast er An Inf lat ion Derivat ives Primer May 2003, Ciaran OHagan

Some examples of trades suggested recently:
A deflation trade.
Breakeven inflation in $ can fall.
Pay US inflation outright at 180bp, 10-years. The D-word,
deflation, is back. This is the highest breakeven in any
market in euro and dollars.
An option trade, also playing deflation.
Benefit from falling inflation in euro.
Buy an inflation floor in at 40 cents (or 8.5bp
embedded in a swap). The closer we get to deflation, the
more attractive such floors should be for investors. The
price was three times as dear just a short time ago. It came
off because investors hunt down premium in a risk-loving,
carry-chasing, markets
A relative value trade.
Same currency, but breakevens are almost 20bp apart.
Sell breakeven inflation in 10-year $ swap @ 180bp;
buy it in 2012 TIP against US Treasury @ 161bp.
There is no fundamental reason why they should trade
differently (both levels are breakevens so credit is not an
explanation). True, inflation swaps are zero coupons and
to swap out a TIP, this would be on a par/par basis, but it
does not explain the sizeable difference.

A dollar/euro relative value trade:
breakeven to fall relative to the $. 16bp spread.
Pay 9-year inflation in euro in swaps @ 177bp
breakeven; buy breakeven inflation in 2012 TIP
against US Treasury @ 161bp. The rise of the euro
should lead to lower inflation in Europe, higher in the US.
Growth differentials also clearly favour this trade. Relative
value in swaps/bonds is the sweetener.
A curve trade in .
French inflation curve too steep vs euro inflation.
- Pay euro 5-year with tobacco at breakeven of 1.88%.
Receive French 5-year with tobacco at breakeven of
1.65%. Spread: 23bp.
- To avoid EUR/French basis, we do the opposite trade
in the 10-year sector. Receive euro 10s with tobacco
at breakeven of 1.92%. Pay French 10s with tobacco
at breakeven of 1.80%. Spread: 12bp.
- Net pick up: 11bp.
Further Information Inflation Swaps

For further information on inflation bonds, see our 60-page
booklet: Introduction of Inflation-Linked Bonds, Albert
Brondolo and Ciaran OHagan, April 2003.

The unrevised HICP index can be found on Reuters on the
HICPFIX page. It is also published in the Euro area
statistics section of the ECBs monthly bulletin
(www.ecb.int). The unrevised HICP ex-tobacco index is
published by the French Treasury in the OATei section of their
website (www.aft.gouv.fr).

Inflation measures on Bloomberg can be found under ECST
and going to the relevant country.
French Less Tobacco Level FRCPXTOB
French Monthly % Change FRCPXTOM
French Yearly % Change FRCPXTOY

Euro zone indexes are also available under EUST

Indexed bonds are all grouped under the very useful page, ILB

FR0000571424 FRTR 3% 25/7/2009
FR0000188013 FRTR 3% 25/7/2012
FR0000186413 FRTR 3.4% 25//729
FR0000188799 FRTR 3.15 07/32

Swap Screens.
There are unfortunately still no screens where prices for
inflation swaps are posted that we are aware of, at the time of

I, Ciaran OHagan, hereby certify (1) that the views expressed in this research report accurately reflect my/our personal views about any or all of the
subject securities or issuers referred to in this report and (2) no part of my/our compensation was, is or will be directly or indirectly related to the specific
recommendations or views expressed in this report.

Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copies of these reports
and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; +1 212 526-6268) or Valerie Monchi (vmonchi@lehman.com; +44 20

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