What Are Inflation Derivatives?
Inflation derivatives are a subclass of derivatives contracts used by investors or firms to manage the potential negative impact of rising inflation levels or speculate on future inflation levels.
Like other derivatives including options or futures, inflation derivatives allow individuals to participate in price movements of an underlying market or index, in this case, a Consumer Price Index (CPI).
- Inflation derivatives are contracts that use an index of inflation, such as the CPI, as its underlying instrument.
- Inflation derivatives can help investors hedge against the risk of increasing prices eroding the real value of their investment portfolio.
- While other products like TIPS also offer inflation protection, inflation derivatives like zero-coupon swaps are much more versatile and may be more cost-effective.
Understanding Inflation Derivatives
Inflation derivatives describe a range of strategies from relatively simple swaps to more complex futures and options products. The most common form of an inflation derivative is an inflation swap, which allows an investor to secure an inflation-protected return relative to an index, like the CPI. The CPI is a measure of the general cost of goods and services in an economy.
In a swap, one investor agrees to pay a counterparty a fixed percentage of a notional amount in exchange for a floating rate payment or payments. The change in inflation over the course of the contract will determine the value of the installment. The calculation between the fixed and floating values is at predetermined intervals. Depending on the shift in the compounded inflation rate, one party will post collateral to the other party.
Example: Zero-Coupon Inflation Swaps
In so-called zero-coupon inflation swaps, a single payment is made by one party or the other at the maturity of the contract. This single-pay contrasts to swaps where the submission of payments happen throughout the deal in a series of exchanges.
For example, take a five-year zero-coupon swap in which Party A agrees to pay a fixed rate of 2.5%, compounded annually, on an amount of $10,000 while Party B agrees to pay the compounded rate of inflation on that principle. If inflation outpaces 2.5%, Party A has come out on top, if not, Party B nets a profit. In either case, Party A has expertly used the swap to transfer their own inflation risk to another individual.
While inflation swaps are often held through maturity, investors do have the option of trading them on exchanges or through over-the-counter markets before their contract expires. Again, if the rate of inflation on the swap is higher than the fixed rate the investor is paying on it, the sale will result in a positive return which is classified by the IRS as a capital gain.
Alternatives to Inflation Derivatives
Other inflation hedging strategies include purchasing Treasury Inflation-Protected Securities (TIPS) or the use of commodities like gold and oil that tend to rise with inflation. These methods, however, do have certain disadvantages when compared to inflation derivatives, including larger investment minimums, transaction fees, and higher volatility. Given their low premium requirements, a wide range of maturities, and low correlation to equities, inflation derivatives have become a common product for investors looking to manage inflation risk.