How are inflation swaps priced?
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.
Is an inflation swap an interest rate swap?
CPI swaps are a type of interest-rate swap in which the fixed payment is based on the current, expected rate of inflation and the variable payment is based on the actual rate of inflation. The actual rate of inflation is measured by the cumulative change in the headline CPI, which includes food and energy.
What does the swap curve tell you?
In other words, the swap curve shows investors the possible return that can be gained for a swap on different maturity dates. The longer the term to maturity on an interest rate swap, the greater its sensitivity to interest rate changes.
What does it mean when swap rates increase?
If interest rates rise during the term of the swap agreement, then the party receiving the floating rate will profit and the party receiving the fixed rate will incur a loss.
Where are inflation swaps traded?
Inflation swaps trade in a dealer-based over-the-counter market. The predominant market makers are the G14 dealers, which trade with one another and with their customers.
Are inflation swaps OTC?
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.
What impacts swap spreads?
The greater the risk of breaking that promise to pay, the higher the swap spread. Swap spreads correlate closely with credit spreads as they reflect the perceived risk that swap counterparties will fail to make their payments.
Why do swap spreads widen?
Swap spreads in general widened as market participants put premiums on counterparty risk.
What factors affect swap spread?
Per the existing literature, the factors affecting the term structure of swap spreads are liquidity, default risk, the level and slope of the yield curve, and the demand and supply of government debt securities (Sun, Sundaresan, and Wang, 1993; Choudhry, 2008; Kobor, Shi, and Zelenko, 2005).
What affects swap spread?
Because a Treasury bond (T-bond) is often used as a benchmark and its rate is considered to be default risk-free, the swap spread on a given contract is determined by the perceived risk of the parties engaging in the swap. As perceived risk increases, so does the swap spread.
What are inflation Breakevens?
Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality. If inflation averages more than the break-even, the inflation-linked investment will outperform the fixed-rate.
What would cause swap spreads to widen?
Swap Spreads as an Economic Indicator Therefore, larger swap spreads means there is a higher general level of risk aversion in the marketplace. It is also a gauge of systemic risk. When there is a swell of desire to reduce risk, spreads widen excessively.
Why are swap spreads widening?
Why do swap spreads tighten?
As year-end approaches, there is increasing Treasury repo funding pressure, which will drive swap spreads tighter. This is because when paying fixed in swaps, the LIBOR rate is earned while the repo rate is paid to finance a long Treasury position.
What does it mean to long the swap spread?
In trading terms, a bet that the spread between swap interest rates and government in- terest rates will widen is called being long the spread. 1 A bet that the spread between swap interest rates and government interest rates will shrink is called being short the swap spread.
What are some problems that might result from high and variable rates of inflation?
High and volatile inflation is not good for business confidence partly because firms cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending which might then damage a country’s productivity growth and long run productive potential.
Why do swaps spread negatively?
Perhaps the most notable reason for negative swap spreads has been regulation. The regulatory requirement for central clearing of most interest rate swaps (except for swaps with commercial end users) has removed counterparty risk from such swap contracts.
What does a negative swap spread imply?
Swap spread turned negative, meaning that swap rates have dipped below yields on corresponding U.S. Treasuries. Swap rates are fixed rates charged as part of interest rate swaps – derivative contracts to exchange fixed interest payments for floating (typically Libor).