Inflation Derivatives: Meaning, Example, Alternatives

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).

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. 

Inflation Derivative Example: Zero-Coupon Inflation Swaps

In so-called zero-coupon inflation swaps, a single payment is made by one party 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 (OTC) 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 for the investor paying the fixed rate, which is classified by the IRS as a capital gain.

Inflation Derivative Alternatives

Other inflation hedging strategies include purchasing Treasury Inflation-Protected Securities (TIPs) or the use of commodities such as 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.