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 rate of inflation it is an exchange of cash flows that allows investors to either reduce or increase their exposure to the changes in the purchasing power of money a zcis is sometimes known as a breakeven inflation swap understanding a zero coupon inflation swap zcis an inflation swap is a contract that transfers inflation risk from one party to another through an exchange of fixed cash flows a zcis is a basic type of inflation derivative where an income stream tied to the inflation rate is exchanged for an income stream with a fixed interest rate a zero coupon security does not make periodic interest payments during the life of the investment instead a lump sum is paid on the maturity date to the security holder likewise with a zcis both income streams are paid as one lump sum payment when the swap reaches maturity and the inflation level is known the payoff at maturity depends on the inflation rate realized over a given period as measured by an inflation index in effect the zcis is a bilateral contract used to provide a hedge against inflation while payment is typically exchanged at the end of the swap term a buyer may 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 referred to as the fixed leg while the other end of the derivatives contract is the inflation leg the fixed rate is called the breakeven swap rate even though the two parties may not actually end up with even payouts the payments from both legs 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 rises the buyer earns more if inflation falls the buyer earns less computing the price of a zero coupon inflation swap zcis the inflation buyer pays a fixed amount known as the fixed leg this is the inflation seller pays an amount given by the change in the inflation index known as the inflation leg this is inflation leg a i e i s 1 where a reference notional of the swap r the fixed rate t the number of years i e inflation index at the end maturity date i s inflation index at the start date begin aligned text inflation leg a times text i text e div text i text s 1 textbf where a text reference notional of the swap r text the fixed rate t text the number of years text i text e text inflation index at the end maturity date text i text s text inflation index at the start date end aligned inflation leg a ie is 1 where a reference notional of the swapr the fixed ratet the number of yearsie inflation index at the end maturity dateis inflation index at the start date example of a zero coupon inflation swap zcis assume that two parties enter into a five year zcis with a notional amount of 100 million a 2 4 fixed rate and the agreed upon inflation index such as the consumer price index cpi at 2 0 when the swap is agreed upon at maturity the inflation index is 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 begin aligned text fixed leg 100 000 000 times 1 024 5 1 100 000 000 times 1 1258999 1 12 589 990 68 text inflation leg 100 000 000 times 0 025 div0 020 1 100 000 000 times 1 25 1 25 000 000 00 end aligned fixed leginflation leg 100 000 000 1 024 5 1 100 000 000 1 1258999 1 12 589 990 68 100 000 000 0 025 0 020 1 100 000 000 1 25 1 25 000 000 00 the fixed leg counterparty received a lump sum payment of 12 59m at expiration but had to pay out 25 0m resulting in a net loss since the compounded inflation rate rose above 2 4 the inflation buyer profited the inflation seller would have profited if the inflation index dropped below 2 25 because at that rate they would have broken even special considerationsthe currency of the swap determines the price index used to calculate the inflation rate for example a swap denominated in u s 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 swap denominated in british pounds would typically be based on great britain s retail price index rpi like every debt contract a zcis is subject to the risk of default from either party either because of temporary liquidity problems or more significant structural issues such as insolvency both parties may agree to put up collateral for the amount due to mitigate this risk other financial instruments that can be used to hedge against inflation risk are real yield inflation swaps price index inflation swaps treasury inflation protected securities tips municipal and corporate inflation linked securities inflation linked certificates of deposit and inflation linked savings bonds benefits of inflation swapsthe advantage of an inflation swap is that it provides an analyst with a reasonably accurate estimation of what the market considers to be the break even inflation rate conceptually it is very similar to how 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 agree based on their respective takes on what the inflation rate is likely to be for the 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 against or speculating on interest rate risk their focus is solely on the inflation rate 