5.3 Inflation Swap Processing

An inflation swap is a contract used to transfer inflation risk from one party to another through an exchange of fixed cash flows.

In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI). The party paying the floating rate pays the inflation adjusted rate multiplied by the notional principal amount. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.

Inflation Swaps (IIS) are derivatives contracts that enable one counterparty to transfer inflation risk to another. There are three types of the Inflation Swaps;
  • Zero-coupon Swap (ZCIS) - The standard form in the inter-bank market is a Zero-coupon Swap, where the accrued inflation payment is only made at maturity based on the final index level, in exchange for the accrued fixed flows.
  • Inflation Revenue Swap (INIS) (also called Inflation Income Swap). - It is an aggregation of the Zero-coupon Swaps.

Inflation Revenue Swap Indexation lag exist for INS because it takes time to process consumer price data and compute inflation numbers. Due to delay in processing time, price index is typically announced about two weeks after the month under consideration. The lag is currently 2 months in GBP, 3months in USD and EUR.