What is a zero coupon inflation swap (ZCIS)?
A zero coupon inflation swap (ZCIS) is a type of derivative in which a fixed rate payment on a notional amount is exchanged for a payment at the inflation rate. It is an exchange of cash flows that allows investors to reduce or increase their exposure to changes in the purchasing power of money.
A ZCIS is sometimes known as an equilibrium inflation swap.
- A zero coupon inflation swap (ZCIS) is a type of inflation derivative, where an income stream that is tied to the inflation rate is exchanged for an income stream with a fixed interest rate.
- With a ZCIS, both income streams are paid as a single lump sum when the swap reaches maturity and the level of inflation is known, rather than exchanging periodic payments.
- As inflation increases, the inflation buyer receives more from the inflation seller than he paid.
- Conversely, if inflation falls, the inflation buyer receives less from the inflation seller than he paid.
Understanding a Zero Coupon Inflation Exchange (ZCIS)
An inflation swap is a contract that is used to transfer inflation risk from one party to another through an exchange of fixed cash flows. In a ZCIS, which is a basic type of inflation derivative, an income stream tied to the inflation rate is exchanged for an income stream with a fixed interest rate. A zero coupon security makes no periodic interest payments over the life of the investment. Instead, a lump sum is paid on the maturity date to the security holder.
Also, with a ZCIS, both income streams are paid as a single payment when the swap reaches maturity and the level of inflation is known. The reward at maturity depends on the inflation rate obtained over a given period of time, measured by an inflation index. In effect, the ZCIS is a bilateral contract that is used to provide a hedge against inflation.
While the payment is generally exchanged at the end of the swap term, a buyer can choose to sell the swap on the over-the-counter (OTC) market prior to maturity.
Under a ZCIS, the inflation receiver, or buyer, pays a predetermined fixed rate and, in return, receives an inflation-linked payment from the inflation payer or seller. The side of the contract that pays a fixed rate is called the fixed tranche, while the other end of the derivatives contract is the inflation tranche. The fixed rate is called the equilibrium swap rate.
The payments of both branches capture the difference between expected and actual inflation. If actual inflation exceeds expected inflation, the resulting positive return to the buyer is considered a capital gain. As inflation increases, the buyer earns more; if inflation falls, the buyer earns less.
Calculate the price of a zero coupon inflation swap (ZCIS)
The inflation buyer pays a fixed amount, known as a fixed leg. This is:
Fixed leg = A * [(1 + r)
t – 1]
The inflation seller pays an amount given by the change in the inflation rate, known as the inflation bracket. This is:
Inflation leg = A * [(I
S) – 1]
- A = Reference notional of the swap
- r = The fixed rate
- t = The number of years
- Ime = Inflation index at the end (maturity)
- IS = Inflation index at the start date
Example of a zero coupon inflation swap (ZCIS)
Suppose two parties enter a five-year ZCIS with a notional amount of $ 100 million, a fixed rate of 2.4%, and the agreed inflation rate, such as the Consumer Price Index (CPI), at 2.0% when the swap it is agreed. At maturity, the inflation index stands at 2.5%.
Fixed leg = $ 100,000,000 * [(1.024)5 – 1)] = $ 100,000,000 * [1.1258999 – 1]
= $ 12,589,990.68
Inflation leg = $ 100,000,000 * [(0.025 ÷ 0.020) – 1] = $ 100,000,000 * [1.25 – 1]
= $ 25,000,000.00
Since the compound inflation rate rose above 2.4%, the inflation buyer benefited; otherwise, the inflation seller would have benefited.
The swap currency determines the price index that is used to calculate the inflation rate. For example, a swap denominated in US dollars would be based on the CPI, a proxy for inflation that measures price changes in a basket of goods and services in the United States. Meanwhile, a sterling-denominated swap would normally be based on Britain’s Retail Price Index (RPI).
Like any debt contract, a ZCIS is subject to the risk of default by either party, either due to temporary liquidity problems or more significant structural problems, such as insolvency. To mitigate this risk, both parties can agree to provide a guarantee for the amount owed.
Other financial instruments that can be used to hedge against inflation risk include real yield inflation swaps, price index inflation swaps, Treasury Inflation Protected Securities (TIPS), municipal and corporate linked securities. inflation, inflation-linked certificates of deposit and inflation. linked savings bonds.
Benefits of inflation swaps
The advantage of an inflation swap is that it provides the analyst with a fairly accurate estimate of what the market considers the “equilibrium” inflation rate to be. Conceptually, it is very similar to the way a market sets the price of any commodity, that is, the agreement between a buyer and a seller (between supply and demand), to carry out transactions at a specific rate. In this case, the specified rate is the expected inflation rate.
Simply put, the two parties to the swap come to an agreement based on their respective opinions on what the likely inflation rate will be for the time period in question. As with interest rate swaps, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged), but instead of hedging or speculating on interest rate risk, its focus is solely on the rate of inflation.