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.