Understanding and Trading Inflation Swaps and Options

Brice Bénaben, Hervé Cros and Franck Triolaire

Inflation is certainly one of the most watched, analysed and, to some extent, feared economic phenomena. One of the reasons is its widespread impact on every individual, company and country, albeit different economic players have different sensitivities to inflation.

Specifically, some economic agents, such as pension funds and insurance companies, are concerned by the possibility of an unexpected rise in inflation, which would require higher cashflows to service their benefits payable, the latter often fixed in real terms. In contrast, other economic agents, such as utility and infrastructure financing companies, and to some extent central and local governments, have revenues correlated to inflation, and therefore are more concerned by unexpected disinflation or deflation, which negatively impact on the nominal amount of cashflow receivables.

The recognition of inflation as an important macroeconomic factor and the efforts to mitigate and manage this risk have clearly influenced both policymakers and financial markets. In terms of policy, one major development has been the adoption of inflation-targeting monetary policies, which have become standard in most countries. These