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Definition: Inflation Derivatives
A kind of derivative that may be put to use by investors to lessen the impact of potentially high value of inflation. Inflation swaps are the most popular kind of inflation derivatives. In this, cash flows of a counterparty have to be synched to a price index and the other counterparty has to be related to a traditional fixed or floating cash flow.
Most of the investors want inflation protection from derivatives since in a completely opposite sense of inflation-indexed bonds, a huge amount of capital is not demanded and therefore it tends to provide more flexibility. The buyer has to provide the swap provider with a small premium to the swap provider in order to have an Inflation derivative. In almost all the situations the Consumer Price Index (CPI) is used analyse the differences in inflation calculated annually.
An inflation derivative acts as a hedge against inflation risk. If left unnoticed, increasing inflation would eat into investment value created over time and drastically reduce a portfolio’s real return. Inflation derivatives offer a flexible and a highly liquid path to entrap returns pegged to future inflation growth, thus helping in managing this risk. The most used type of these derivatives is an inflation swap (also called as a CPI swap since it is linked to the Consumer Price Index)
Talking about the risks involved, all investments, including inflation derivatives, come along with specific risks that should be evaluated carefully. These securities may be more complicated than most stock and bond investments, but they still consist of same considerations on liquidity and potential defaults. These are the main reasons investors wanting to consider portfolios which are professionally managed, for example mutual funds, to gain access to these inflation-hedged securities.
US inflation derivative market has been growing since 2007-08 crisis, as seen in the above figure.