how an inflation swap works
inflation swaps are used by financial professionals to mitigate hedge the risk of inflation and to use the price fluctuations to their advantage many types of institutions find inflation swaps to be valuable tools payers of inflation are typically institutions that receive inflation cash flows as their core line of business a good example might be a utility company because its income is linked either explicitly or implicitly to inflation one party to an inflation swap will receive a variable floating payment linked to an inflation rate and pay an amount based on a fixed rate of interest while the other party will pay that inflation rate linked payment and receive the fixed interest rate payment notional amounts are used to calculate the payment streams zero coupon swaps are most common where the cash flows are swapped only at maturity as with other swaps an inflation swap initially values at par or face value as interest and inflation rates change the value of the swap s outstanding floating payments will change to be either positive or negative at predetermined times the market value of the swap is calculated a counterparty will post collateral to the other party and vice versa depending on the value of the swap benefits of inflation swapsthe advantage of an inflation swap is that it provides an analyst with a fairly accurate estimation of what the market considers to be the break even inflation rate conceptually it is very similar to the way that a market sets the price for any commodity namely the agreement between a buyer and a seller between demand and supply to transact at a specified rate in this case the specified rate is the expected rate of inflation simply put the two parties to the swap come to an agreement based on their respective takes on what the inflation rate is likely to be for the period of time 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 against or speculating on interest rate risk their focus is solely on the inflation rate inflation swap examplean example of an inflation swap would be an investor purchasing commercial paper at the same time the investor enters into an inflation swap contract receiving a fixed rate and paying a floating rate linked to inflation by entering into an inflation swap the investor effectively turns the inflation component of the commercial paper from floating to fixed the commercial paper gives the investor real libor plus credit spread and a floating inflation rate which the investor exchanges for a fixed rate with a counterparty 