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Infinance,inflation derivative (or inflation-indexed derivatives) refers to anover-the-counter and exchange-tradedderivative that is used to transferinflation risk from one counterparty to another. SeeExotic derivative.
Typically,real rate swaps also come under this bracket, such asasset swaps ofinflation-indexed bonds (government-issued inflation-indexed bonds, such as theTreasury Inflation Protected Securities, UK inflation-linkedgilt-edged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and JapaneseJGBis are prominent examples).Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floatinginterest rate swaps (which are the derivative form for fixed rate bonds), but use areal rate coupon versusfloating, but also pay aredemption pickup atmaturity (i.e., the derivative form ofinflation-indexed bonds).
Inflation swaps are typically priced on azero-coupon basis (ZC) (likeZCIIS for example), with payment exchanged at the end of the term. One party pays thecompounded fixed rate and the other the actualinflation rate for the term. Inflation swaps can also be paid on ayear-on-year basis (YOY) (likeYYIIS for example) where the year-on-year rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though thecoupons are paid monthly, theinflation rate used is still the year-on-year rate.
Options on inflation includinginterest rate cap and floors andstraddles can also betraded. These are typically priced against YOY swaps, whilst theswaption is priced on theZC curve.
Asset swaps also exist where thecoupon payment of the linker (inflation bond) as well as theredemption pickup atmaturity is exchanged forinterest rate payments expressed as apremium ordiscount toLIBOR for the relevantbond coupon period, all dates areco-terminus. Theredemption pickup is the abovepar redemption value in the case of par/parasset swaps, or the redemption above the proceedsnotional in the case of the proceedsasset swap. The proceedsnotional equals thedirty nominal price of the bond at the time of purchase and is used as thefixed notional on theLIBOR leg.
Real rate swaps are thenominal interest swap rate less the corresponding inflation swap. As for modelling, the trend has been either to provide:
