Inflation Derivatives: Everything You Need to Know

Summary:

Inflation derivatives allow investors to transfer their inflation-related risks. Using this method, an agreement is established between two parties at a predetermined rate. The term of an inflation swap depends on the inflation index. A portfolio consisting of customer price index (CPI) swaps and short-duration securities can reduce risks for investors in the current volatile market.

According to the National Stock Exchange (NSE), approximately 34 lakh retail investors participated in derivative trading in June 2023. The numbers are quite impressive. But trading in derivatives comes with its own set of challenges and opportunities. Most financial institutions (FIs) have to deal with inflation risks in their trading activities. And, this is where inflation derivatives come in. They empower traders to safeguard their interests by shifting these inflation-related risks to others engaged in trading.

The value of inflation indices determines the payoff of inflation derivatives. In other words, inflation derivatives, which are a subclass of derivatives contracts, are used to control the potential negative effect of inflation levels. Just like options or futures, it allows traders to take part in the price movements of an underlying market or index. Think of inflation derivatives as financial umbrellas for FIs facing the rain of inflation risk in their operations. Just as an umbrella shields you from getting wet during a downpour, inflation derivatives protect FIs from the negative effects of rising inflation. And the derivatives function much like a rain gauge, where the amount of rainfall (representing inflation) is measured by the inflation indices. 

Inflation derivatives: A holistic perspective

Inflation derivatives include various kinds of strategies such as simple swaps, futures products, and options instruments. One of its most common types is an inflation swap. It enables investors to obtain an inflation-protected return linked to an index, such as the CPI. Inflation indices are commonly produced by statistical agencies. They are represented by “baskets of goods” based on consumer expenditure patterns. In this context, CPI emerges as an important metric. It is used to measure the general cost of goods and services in a particular economy.

Inflation derivatives users: Understanding the players

Delving into the world of inflation derivatives, it's essential to grasp the diverse array of users involved. Let's explore the key players in this financial landscape:

• Market makers who leverage inflation-linked derivatives to hedge inflation-indexed bonds
• Corporates who want to offset or match future liabilities
• Companies that have high inflation exposure
• Investors to mitigate portfolio risks associated with increasing inflation levels. It acts as a layer of protection for investors

Exploring inflation derivatives: Unveiling the types

Within the realm of inflation derivatives, it's vital to explore the diverse categories that define this financial domain. These encompass:

• Inflation swaps: The most common kind is an inflation swap where two parties exchange a fixed payment for a variable one which is linked to an inflation index like the CPI.
• Inflation options: Here, holders get the right to buy (call option) or sell (put option) an underlying inflation index at strike price.
• Inflation futures: These standardised contracts, traded on organised exchanges, offer traders the opportunity to speculate on the future direction of inflation.
• Inflation-linked bonds: Here, the principal is linked to an inflation index such as treasury inflation-protected securities (TIPS). Investors receive regular interest payments that are linked to fluctuations in the CPI. 
• Inflation-linked certificates of deposit (CDs): Some banks provide inflation-linked CDs. In this case, the return is dependent on the changes in an inflation index.
• Inflation-linked structured products: These products come with exposure to inflation movements and are created by FIs. The products can be tailored as per investment objectives.

Inflation derivatives decoded: Real-world scenario

A swap is generally referred to as an instance where an investor pays a predetermined percentage of a notional amount and gets a floating rate payment in exchange. The value of the installment depends on the change in inflation during the period. Inflation swaps are typically valued based on a zero-coupon framework, with payments exchanged after the agreement's term. Rather than receiving periodic interest payments, the accrued interest is combined and paid as a single net sum at the conclusion of the swap term.  As inflation swaps often occur through maturity, investors cannot trade them on the exchange or over-the-counter (OTC) market before the contract expires.  When the inflation rate on the swap is more than the fixed rate, the sale will lead to a positive return for the investor paying the fixed rate.

Consider a five-year zero-coupon swap on a principal amount of INR 10,000. Say Party A has committed to paying a fixed compounded annual rate of 2.5% on the principal amount, while Party B has agreed to pay the compounded inflation rate on that same principal amount. In this scenario, party A profits if inflation crosses 2.5%. Or else, the swap benefits party B. In either case, the inflation risk has been expertly transferred by party A to another individual with the swap.

Calculating inflation derivatives: A quick look

The value of inflation derivatives is fixed at predetermined intervals. Based on the compounded inflation rate change, one party provides collateral to another. Before entering into the contract, the involved parties reach a consensus on several key aspects. This includes the selection of a notional amount, which serves as the principal sum for calculating cash flows but is typically not physically exchanged. Additionally, they establish a maturity date and agree upon the fixed rate that will be subject to exchange. To mitigate the risk of counterparty default, both parties are required to provide collateral. 

Let’s simplify this with an example.

Imagine two people, A and B, who want to make a financial agreement. They decide on the following terms:

1. Notional amount: They choose a notional amount of INR 1,00,000. This is the base amount they will use for calculations but won't actually exchange.
2. Maturity date: They agree that this agreement will last for one year.
3. Fixed rate: They decide on a fixed interest rate of 5%.
4. Collateral: To make sure both A and B fulfill their promises, they each deposit INR 10,000 as collateral.

Now, during the year, if the market interest rate goes above 5%, A pays B the difference. So, if the market rate becomes 6%, A will pay B (6% - 5%) of the notional amount (INR 1,00,000), which is INR 1,000. Conversely, if the market rate falls below 5%, B will pay A the difference. At the end of the year, they return each other's collateral. This way, they've agreed to exchange the difference between the fixed rate and the market rate, providing some protection against interest rate fluctuations.

Inflation protection without derivatives: Alternative approaches

Another significant hedging approach involves the acquisition of treasury inflation-protected securities (TIPS). This method entails investing in commodities known to be strongly influenced by inflation, like gold and oil. So, it is essential to consider its drawbacks, including transaction fees, substantial volatility, and higher minimum investment requirements before investing.

Investors who want to play a little safe and want to protect themselves usually opt for inflation derivatives. They also find favour in this strategy due to the wide range of available maturities, low premiums, and its reduced correlation with equities.

Mastering inflation derivatives: Expert guidance for success

The traditional method of hedging comes with its own share of risks. If you share these concerns, it's time to make a prudent choice. Inflation-linked derivatives are a great way to reduce risks. Partner with one of India’s leading brokers to learn all about the trading landscape. Make informed decisions with easy-to-use tools to trade in futures and options, beat inflations, and grow your wealth.