Zero Coupon Inflation Swap

A zero coupon inflation swap is a swap which pays the difference between the change in the underlying inflation index and the fixed rate of the swap.

The market on inflation-based swaps is diverse both in terms of products and inflation indexes. Currently in SDX Interest Rates you can price a zero coupon inflation swap. This is the most basic inflation swap.

In a zero coupon inflation swap:

The fixed leg is compounded according to the frequency chosen for the trade and paid once at maturity.

In SDX Interest Rates the coupon to be paid by the fixed leg is shown as a mid rate in the Zero Rate field, and as a bid/ask format in the Market Rate field in the Results area.

In SDX Interest Rates, for each index the zero coupon swap rates are based on the data in the Inflation Curve page (See "Inflation Curve").

The floating leg is the realized growth of the appropriate inflation index.

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 Zero Coupon Inflation Swap

A zero coupon inflation swap lets market participants:

See the market’s forecast of future realized inflation.

Hedge against or speculate on future inflation fluctuations.

Evaluate inflation linked securities, including asset swapping TIPS and other securities.

Hedge against central bank credit tightening policies (due to the fact that central banks will tighten monetary policy to fight rising inflation).

Zero coupon inflation swaps can be used by:

Borrowers whose incoming cash flows are linked to an inflation index but whose loan repayments are fixed or linked to another interest rate index. Such borrowers can use an inflation swap index to let them link their liability payments to the inflation index instead.

Investors to protect the revenues received on their investments against inflation.

Pricing a Zero Coupon Inflation Swap in SDX Interest Rates

When pricing a zero coupon 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 zero coupon 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 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.