Inflation Swap

An inflation swap is a financial derivative contract in which two parties agree to exchange cash flows based on a notional principal amount, one linked to a floating inflation rate and the other to a fixed rate. The floating rate is typically based on the consumer price index (CPI), while the fixed rate is typically a government bond yield.

Inflation swaps are used to hedge against inflation risk, which is the risk that the purchasing power of money will decrease over time. For example, a company that expects its costs to rise due to inflation may enter into an inflation swap to lock in a fixed rate for its future expenses.

Inflation swaps can also be used for speculation. For example, an investor who believes that inflation will increase may enter into an inflation swap to receive the floating rate and pay the fixed rate.

The payoff of an inflation swap is determined by the difference between the floating and fixed rates. If the floating rate exceeds the fixed rate, the party that receives the floating rate will pay the difference to the party that receives the fixed rate. Conversely, if the fixed rate exceeds the floating rate, the party that receives the fixed rate will pay the difference to the party that receives the floating rate.

Inflation swaps are typically traded over-the-counter (OTC), meaning that they are not traded on an exchange. This can make them more difficult to trade than other financial derivatives, such as futures and options.

Inflation swaps can be used to hedge against inflation risk, speculate on inflation, or manage interest rate risk. However, they are complex instruments and should only be used by experienced investors.