A Zero-Coupon Inflation Swap (ZCIS): What Is It?
A derivative known as a zero-coupon inflation swap (ZCIS) exchanges a fixed-rate payment on a nominal amount for a fee at the inflation rate. Investors may alter their exposure to fluctuations in the buying power of money via this exchange of cash flows. Another name for a ZCIS is a breakeven inflation swap.
Knowing How to Interpret a Zero-Coupon Inflation Swap (ZCIS)
A contract known as an inflation swap exchanges fixed payment flows to transfer inflation risk from one party to another. A ZCIS is a simple inflation derivative in which an income stream with a fixed interest rate is swapped for an income stream linked to the inflation rate. No interest is paid on a zero-coupon security for the investment. Instead, the security holder receives a lump-sum payment on the maturity date.
Similarly, when a ZCIS matures and the inflation rate is known, both income streams are paid as a single lump sum. The maturity payout is determined using an inflation index to assess the actual inflation rate over a specific period. The ZCIS is essentially a bilateral contract that serves as an inflation hedge.
A buyer can sell the swap before it matures, even though money is usually exchanged on the over-the-counter (OTC) market after the swap period.
In a ZCIS, the inflation payer, or seller, provides an inflation-linked payment to the inflation receiver, or buyer, in exchange for paying a specified fixed rate. The fixed leg of the derivatives contract is the side that pays a set rate, while the inflation leg is the opposite end of the contract. Although the two parties may not truly get equal payments, the set rate is known as the breakeven swap rate.
The payments from both legs capture the actual inflation difference. A capital gain is a favorable return to the buyer if real inflation surpasses expectations. The buyer makes more when inflation increases and less when inflation decreases.
How Much a Zero-Coupon Inflation Swap Would Cost (ZCIS)
The inflation buyer pays the fixed leg, or a set amount. That is:
Fixed Leg = A * [(1 + r)t – 1]
The variation in the inflation index determines the inflation leg, which the inflation seller pays. That is:
Inflation Leg = A * [(IE ÷ IS) – 1]
Where
A = the swap’s reference notional
R is the set rate.
t = the total years
IE stands for the inflation index on the maturity date.
IS = the starting date’s inflation index
An illustration of a ZCIS (zero-coupon inflation swap)
Let us assume that, upon agreement, two parties sign into a five-year zero-coupon swap (ZCIS) with a nominal value of $100 million, a fixed rate of 2.4%, and an agreed-upon inflation index, say the Consumer Price Index (CPI), at 2.0%. The inflation index is 2.5% at maturity.
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
At expiry, the fixed-leg counterparty was paid a lump sum of $12.59 million, but they also had to pay out $25.0 million, which left them with a net loss. The inflation buyer made money since the compound inflation rate increased beyond 2.4%; conversely, the inflation seller would have made money if the inflation index fell below 2.25%, as they would have broken even at that rate.
Particular Points to Remember
The swap’s currency determines the price index used to calculate the inflation rate. For instance, an exchange valued in US dollars would be based on the CPI, a stand-in for inflation that tracks increases in the cost of various American products and services. On the other hand, the Retail Price Index (RPI) of Great Britain serves as the basis for an exchange value in British pounds.
A ZCIS, like any debt contract, has the potential to default on either side due to various circumstances, including transient liquidity challenges or more serious structural problems like bankruptcy. To lessen this risk, both parties may pledge collateral in the amount owed.
Real yield inflation swaps, price index inflation swaps, Treasury inflation-protected securities (TIPS), inflation-linked savings bonds, inflation-linked certificates of deposit, municipal and corporate inflation-linked securities, and inflation-linked certificates of deposit are additional financial instruments that can be used to protect against inflation risk.
Advantages of Swaps for Inflation
One benefit of using an inflation swap is that it gives an analyst an estimate of the market’s “breakeven” inflation rate, which is entirely accurate. It functions similarly to how a market determines the price of anything or a service: it involves a buyer and a seller agreeing to trade at a specific rate (based on supply and demand). In this instance, the stated rate corresponds to the anticipated inflation rate.
In other words, the two parties to the swap agree based on their different estimates of the anticipated inflation rate for the relevant time frame. The parties trade cash flows based on a notional principal amount (this amount is not exchanged), much as in interest rate swaps. Still, their only concern is the inflation rate, rather than interest rate risk hedging or speculation.
A Zero-Cost Inflation Swap: What Is It?
It is known as a zero-coupon inflation swap because no interest is paid on the instrument until it matures. This hedge against inflation protects against inflation. Another investor purchases it, with payment due at maturity based on the inflation rate.
A Zero Coupon Swap: What Is It?
In a zero-coupon swap, one side pays the other fixed interest while the other makes floating payments according to a predetermined interest rate index.
How do you perform an inflation swap?
A contract known as an inflation swap is one in which one party agrees to pay a fixed rate while the other agrees to pay a variable rate based on an inflation index.
The Final Word
When a financial instrument with an inflation-adjusting interest payment is sold to another investor for a set price and delivered at maturity, this is known as a zero-coupon inflation swap. Investors use it as a hedge against inflation.
Conclusion
- When a zero-coupon inflation swap (ZCIS) matures and the inflation level is known, it pays both income streams as a single lump sum rather than exchanging periodic payments.
- ZCISs are an inflation derivative where an income stream tied to the inflation rate is exchanged for an income stream with a fixed interest rate.
- The inflation buyer gets more from the inflation seller than what they paid when inflation increases, and the inflation buyer gets less from the seller than when inflation decreases.
