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Definition: Inflation Swap
Inflation swap is technique of hedging the risk of parties involved in a contract through exchange. There are two parties involved in the arrangement. One party pays the fixed rate on the principal amount whereas the other party pays the floating rate according to the consumer price index. It is a technique of hedging inflation risk in the financial world. The financial instruments are derivatives and commercial paper. When any investor entered into an inflation swap contract, he converts his floating rate into fixed rate. The investor gets the fixed rate of return whereas the counter party will receive total of credit spread, a floating inflation rate and Libor. The inflation swap range is from 0% to 5%.
The original swap arrangement between the pension plan and Counterparty is that Pension plan agrees to pay fixed rate whereas the Counterparty is agreeing to pay LIBOR at maturity.Now, If the interest rates falls the collateral are transfer from counterparty to pension plan.Finally the payments are made according to agreement. ( Fixed by Pension plan and LIBOR payments by counterparty.