Inflation derivatives are a type of insurance used to guard against the effects of inflation on investment value. The most common type of inflation derivative is called a credit swap. This is when one party exchanges cash flow streams with another party. The cash flow stream of the seller is connected to an inflation index and when the inflation index goes up, the buyer receives the return. This return compensates him or her for the loss in value from other investments.
In order to truly understand inflation derivatives and how they help investors to manage risk, it is important to understand what inflation is, or more importantly, how it affects the value of currency and investment assets. Inflation is the increase in the price of goods and services over time. Most countries aim for a rate of inflation of between 2 and 3 percent. It is normally measured on an annual basis. As prices go up, the value of currency goes down. As a result, consumers must pay the same amount for a smaller amount of goods or services.
There are three main types of inflation: deflation, hyperinflation, and stagflation. Deflation is the opposite of inflation. Hyperinflation is the exponential growth of inflation over time. Stagflation is the mix of high unemployment, economic recession, and inflation. The most severe problems arise when inflation is unexpected and markets react with uncertainty about the future direction of the economy.
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One way consumers fight inflation is through wage contracts. Unfortunately, wage contracts can only help to hedge the effects of inflation on a consumer's bank account. Inflation derivatives are used to help manage and reduce risk within an investment portfolio.
Inflation derivatives got their start in the U.K. in the early 1990s. Since that time, the market for various types of inflation derivatives has grown across countries and industries. The Consumer Price Index (CPI) is the most commonly used measure of inflation on an annual basis. Other types of international inflation indices are the French CPI, Eurozone, US CPI, and the UKRPI.
Investors prefer to purchase insurance against inflation through derivatives as they require less upfront capital than traditional inflation indexed bonds. Investors in inflation derivatives must pay a small premium to the seller for coverage. The transaction is a lot like paying for insurance on a car, except inflation protected bonds require the full initial investment value. In most cases this is at least $1,000 U.S. Dollars (USD). Inflation derivatives also tend to be less liquid than inflation indexed bonds, which makes them less risky overall.