A year-over-year inflation cap protects its buyer from a rise in the year-over-year inflation above the level (i.e., the strike) specified in the contract.
It consists of a series of caplets. Each caplet successively ensures the buyer protection against a rise in the year-over-year inflation rate above the strike for a single payment period. That is, if on the caplet’s payment date (usually at the end of the caplet period) its year-over-year inflation rate is above the strike, the cap seller must pay the buyer a payoff as follows:
(Year-over-year inflation change - strike) * notional * relevant daycount fraction
Where:
The year-over-year inflation change is calculated as follows:
End index / ref index
The end index is the inflation index expected on the caplet's end date.
The ref index is the inflation index measured on the date a year prior to the caplet's end date. So, for example, if the caplet’s end date is set to 10 October 2012, the reference index is displayed for 10 October 2011.
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This can also be for a date in the future. |
Advantages of a YoY inflation cap
Because it acts as an upward hedge, buying a cap lets you set a maximum limit on the year-over-year inflation rate exposure for a specified period, while giving you the flexibility to benefit from any reduction in rates.
Pricing a YoY inflation cap
When pricing a YoY inflation cap in the system:
You can price an inflation cap on any of the following currencies, each of which has one or more standard inflation indexes:
GBP which is based on UKRPI. This is the CPI for All Urban Customers (also known as CPI-U).
USD which is based on USCPI.
EUR which can be based on either HICPxT or FRCPI.
Note that each index rolls according to its own convention. For more information, see Understanding the Inflation Index Conventions .
For the strike you can define an absolute strike or enter “a” to indicate the ATM forward strike.
By default, the system sets each caplet’s payment on the relevant caplet’s end date. You can change these dates manually. However, the payment date cannot be prior to the end date.
In the Cash Flow Dates window, the implied rate is the expected % change in the year-over-year inflation rate.
The system:
Needs to know which forward index interpolation method to use.
For more information, See "Selecting the Forward Index Interpolation Method for Inflation Instruments".
Needs to know to deal with seasonality.
For more information, See "Customizing the Seasonality Adjustment for Inflation Instruments".
Needs to know from when to calculate the seasonality.
For more information, see Defining Which Reference Index to Use to Calculate the Seasonality
The system uses inflation rates which are taken by lag definition, even if more recently published rates are available.
When you define the instrument’s tenor, the system automatically displays the default inflation lag for the selected index in the Inflation Lag field. However, you can then edit this value if required. This lets you instruct the system to price the instrument using a non-default inflation lag.
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If you are using seasonality and you have also instructed the system to measure the seasonality using the newest index available, the system does not use the inflation lag for the seasonality calculation, even if you have manually defined the inflation lag in the pricing page itself (in the Inflation Lag field). |