Inflation Swap

What is an 'Inflation Swap'

An inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. In an inflation swap, one party pays a fixed rate on a notional principal amount, while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by he notional principal amount. For example, one party may pay a fixed rate of 3% on a two year inflation swap, and in return receive the actual inflation.

BREAKING DOWN 'Inflation Swap'

Investors use inflation swaps to hedge inflation risk. A more complicated example of an inflation swap would be an investor purchasing commercial paper. At the same time, the investor enters into an inflation swap contract, in which he receives a fixed rate and pays a floating rate linked to inflation. By entering into an inflation swap, the investor effectively turns the inflation component of the commercial paper from floating to fixed. The commercial paper gives the investor real LIBOR plus credit spread plus a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.

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RELATED FAQS
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    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
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    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  3. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
  4. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  5. What is an absolute rate?

    An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >>
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