YoY Inflation Swap

A YoY inflation swap lets you swap a fixed or floating rate with the year-over-year change in the underlying inflation index specified in the contract, i.e., the inflation leg.

One of the parties pays a fixed rate or floating rate and receives the inflation leg; the other party pays the inflation leg and receives the fixed rate or floating rate.

For the inflation leg the cash flow per coupon is calculated as follows:

Year-over-year inflation change * notional * relevant daycount fraction

Where:

The year-over-year inflation change is calculated as follows:

{(End index / ref index) -1} * 100

The end index is the inflation index expected on the coupon end date.

The ref index is the inflation index measured on the date a year prior to the coupon’s end date. So, for example, if the coupon’s end date is set to 10 October 2012, the reference index is displayed for 10 October 2011.

It can be priced for the following currencies, each of which has a standard inflation index:

USD which is based on USCPI. This is the CPI for All Urban Customers (also known as CPI-U).

EUR which can be based on any of the following indices: HICPxT, FRCPIxT, HICP, ITCPI, SPCPI, FRCPI, DECPI (Germany).

GBP

This can be based on UKRPI or LPI.

The LPI in effect adds a collar to the RPI, i.e., a defined floor and, also, a defined cap.

The advantage of using one of the supported LPI options is that you can achieve a more exact hedging of your liabilities. That is, the hedge cashflows will more precisely match the cashflows of the position being hedged. You can choose from the following:

LPI 0-3
This sets the floor to 0 (zero) and the cap to 3%.

LPI 0-5
This sets the floor to 0 (zero) and the cap to 5%.

LPI 3-5
This sets the floor to 3 and the cap to 5%.

LPI Floor 0
This sets the floor to 0 (zero) whereas there is no cap. This option lets you match a liability which just has a “no deflation” condition.

JPY which is based on JPCPI.

AUD which is based on AUCPI.

ILS which is based on CPI/ILS.

Note that each index rolls according to its own convention. For more information, see Understanding the Inflation Index Conventions .

Advantages of a YoY inflation Swap

Any business with a future cash exposure (either positive or negative) has exposure to the inflation rate between the current date and the date of that cash flow. Generally, the further into the future the exposure, the more prudent it is to hedge the inflation risk.

A YoY inflation swap instrument lets you:

Hedge (or speculate on) the difference or spread between an interest rate index and the year-over-year change in the inflation index.

To do this you must set the non-inflation leg to a floating rate.

Simply hedge (or speculate on) the year-over-year change in the inflation index.

To do this you must set the non-inflation leg to a fixed rate.

It also lets you exchange the cash flows on a predefined schedule over the lifetime of the instrument, not just on the instrument's expiry date.

Pricing a YoY Inflation Swap in SDX Interest Rates

When pricing a YoY inflation swap 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.

Needs to know the inflation lag. This is so it knows which inflation rates to use.

To price a YoY inflation swap 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 swap term, 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.