Posted in Finance, Accounting and Economics Terms, Total Reads: 441
Definition: Zero Coupon Inflation Swap
It is a basic type of inflation derivative. In inflation swap, amount that is attached to a known rate of inflation is exchanged with an amount derived by a fixed interest rate. In the zero coupon version instead of paying the amount periodically, whole amount is paid as a lump sum at the time of maturity of the bond.
Based on the side of trade, such an exchange would allow the investor to either increase or decrease his exposure to inflation. The inflation swap works with a known inflation rate. The underlying currency used as exchange in the swap also determines the rate of inflation. E.g. - if the trade happens in US dollar, CCPI of USA will determine the swap denomination.
It is zero coupon because instead of coupon or periodic payment, the cash flows only at maturity of the swap.
It is a swap because it effectively hedges the risk of floating rate of interest which is derived from inflation by a fixed interest payment.
It is an inflation swap because CPI (consumer price index) serves as an underlying asset.
One party pays another a ﬁxed amount = P[(1+R)T-1]
While another party returns the floating amount = P[IM/IS -1]