Handbook of Finance: Financial Markets and Instruments

Chapter 68. Introduction to Inflation Derivatives

JEROEN KERKHOF PhD

Vice President, Morgan Stanley

Abstract: Numerous financial institutions face inflation risk in their activities. Using inflation derivatives allows them to transfer their inflation risk. The payoff of inflation derivatives depends on the value of inflation indices. Inflation indices are constructed by statistical agencies using the value of representative baskets of goods. By linking the payoff of inflation derivatives to representative baskets of goods inflation derivatives allow investors to focus on real rather than nominal returns. A variety of inflation derivatives exist in market and the most common types are the zero-coupon inflation swap and the year-on-year inflation swap.

Keywords: inflation risk, inflation indices, seasonality, nominal returns, real returns, zero-coupon inflation swap, year-on-year inflation swap, real swaptions

Inflation derivatives allow the transfer of inflation risk. For example, pension funds may want to cover their natural liabilities to inflation risk, while utility companies may want to shed some of their natural exposure to inflation risk. In short, inflation derivatives provide an efficient way to transfer inflation risk. Their flexibility allows users to replicate in derivative form the inflation risks embedded in other instruments such as standard cash instruments (that is, inflation-linked bonds). For example, as is explained later, an inflation swap can be theoretically replicated ...