Benefit from inflation

with bonds, swaps, caps and floors

Benefit from inflation

The problem of inflation is nearly as old as currency itself, and inflation-linked products have been around for centuries as well. In this article, consultant Rogier Galesloot discusses the history of inflation-linked products and shows how inflation-linked bonds, swaps, and caps/floors can be of interest to an organization or institution looking to hedge against inflation. 

There have been times in history when inflation rose to double-digit percentages and then there are times, such as the present, when inflation is even negative. During prolonged periods ofextremely high or low inflation, consumers will eventually start feeling the pinch.

Businesses and governments are particularly vulnerable to inflation, as positive and negative cash flows depend on inflation. Examples of this include rents, gas and commodity prices. But there are numerous inflation-linked products available to hedge against this inflation risk.

“In 2008, more than USD 1,500 billion-worth of inflation-linked bonds had been issued worldwide.”

Inflation-linked products

Inflation-linked products have existed since the American War of Independence (1775–1783). During this war the American colonies were weighted down by extremely high war inflation, creating dissatisfaction among American soldiers about the decline in their purchasing power.The state of Massachusetts then decided to issue inflation-linked bonds. By purchasing these bonds, soldiers were able to secure a consistent purchasing power level. Once the war and the attendant high inflation were over, these bonds were forgotten. It was not until the 1980s that inflation-linked bonds were issued again, this time by the British government. These products were designed for pension funds, which used them to hedge against increasing pensions as a result of inflation.In the following years the inflation market grew significantly. Nowadays inflation-linked bonds are issued in more than 40 countries and extensive trade is also conducted in inflation-linked derivatives, such as options. In 2008 more than USD 1,500 billion-worth of inflation-linked bonds had been issued worldwide.

Who uses them?

Inflation-linked products can be of interest to any organization and institution. If income or expenditure depends on inflation, an inflationlinked product – a bond or a derivative – can be used as protection against inflation risk, compensating for increased prices. An organization that collects rent, for example, could use an inflation-linked swap to exchange uncertain future rental income for certain, fixed cash flow. The organization will then be able to base its long-term view on a series of fixed, future cash flows.

Inflation-linked bonds

A significant difference between a conventional bond and an inflationlinked bond is that the principal or the coupon value of the latter is index-linked to inflation. Instead of the principal, the initial principal plus the inflation from that period is repaid on maturity.

Alternatively, an annually indexed coupon can be paid instead of a constant coupon value. An example of such a product is the inflation-linked bond issued by the British government, as mentioned above.  The principal of this bond is indexed each period to the year-on-year change in the British Consumer Price Index (CPI). As a result, the purchasing power of the bond holder is the same on maturity as at the start.

Inflation-linked swaps

In an inflation-linked swap a fixed payment is usually exchanged for an inflation rate. This percentage is also calculated based on the CPI. One way is to divide the CPI at the time of a cash flow by a contractually determined base-rate CPI. Projected annual inflation rates can also be distilled from the forward CPI curve. The structure of an inflation-linked swap is shown in Figure 1.

An inflation-linked swap can be used to exchange the uncertainty of inflation-dependent cash flows for a certain, fixed cash flow.

Fixed interest x Principal
Inflation rate x Principal
Party A pays
fixed interest
Party B pays
inflation

Figure 1: Diagram of an inflation-linked swap

Inflation-linked caps and inflation-linked floors

An inflation-linked cap or inflation-linked floor is a derivative based on inflation. This type of product can be used to hedge against both high and low inflation. An inflation-linked cap generates cash flows if inflation exceeds a certain percentage, known as the strike. An inflation-linked floor, on the other hand, generates cash flows if inflation falls below a certain level. For this category a strike rate of 0% is often used, asprotection against deflation.

Inflation-linked caps and inflation-linked floors can be regarded as options on inflation. A cap can be a useful tool when income suffers from inflation, as in the case of rents. When inflation increases, purchasing power declines. This decline can be compensated for by income from the cap contract.

Table 1: Market value calculation inflation-linked swap

Valuation

The term “CPI” is mentioned several times in the paragraphs above. This index is used in the calculation of cash flows. If an inflation-linked product is issued based on European inflation, the European CPI should be used. Figure 2 shows the annual CPI percentages. It is clear that, even within Europe, there are considerable differences in inflation rates. It is also clear that inflation in the EU, like Dutch and German inflation, leans towards 2%, which is the long-term inflation target for EU member states.

Figure 2: Annual CPI figures

The valuation of inflation-linked derivatives is based on the theory of the valuation of an interest rate derivative. The forward interest rate curve is used to value an interest rate derivative. A forward CPI curve is required to value an inflation-linked derivative. The future, risk-neutral, cash flows are determined based on this curve. A disadvantage of the forward CPI curve is that it is only available in countries where a sufficient number of inflation-linked bonds are issued.

There are currently only six countries in the world besides the European Union where the inflation market liquidity is such that there is also a forward CPI curve. These countries are the United Kingdom, the United States, France, Japan, Australia, and Italy.

As an example, an inflation-linked swap based on European inflation. Party A pays the inflation to party B once a year. In exchange, party B pays a fixed amount of 2% of the principal, i.e. EUR 1 million – see column C in Table 1 above.

  1. First a forward inflation curve must be constructed. The forward CPI curve can be used for this purpose – see column E. The inflation rates are calculated based on the forward CPI curve. The CPI on 31 December 2009 was 107.51.
  2. A discount curve is subsequently constructed, column D. Depending on the payment frequency, a 1-m, 3-m or 6-m curve can be selected.
  3. The uncertain cash flows are estimated based on the information from point 1, see column G.
  4. Using the discount factors from point 2 the present value (PV) of the cash flows is calculated, see columns H and I. In this case the 6-monthly curve is used.
  5. The difference between this market value and the market value of the fixed rate results in the net present value of the swap, i.e. a net present value ofeUR 1,848. At present, therefore, this product has a positive market value for the party paying the inflation.

Illiquid Markets

Many countries have an illiquid inflation-linked bond market. The nonexistence of such a market means that it is difficult to value the derivatives based on this inflation. This problem is examined from a theoretical point of view in the paper on which this article is based. Considered from a practical point of view, there is no obvious solution for countries whose payment instrument is the euro. European inflation can be used as a proxy for the domestic, illiquid inflation market. The situation is considerably more complex in countries where another currency is used. In order to approach this problem in a practical manner, the historical correlations between currency and inflation and the various liquid markets should be examined.