Zero Coupon Inflation Swap

Zero-Coupon Inflation Swap (ZCIS)

A zero-coupon inflation swap (ZCIS) is a derivative that exchanges a single fixed payment for a single inflation-linked payment at maturity. It transfers inflation risk between two parties: one pays a predetermined fixed amount (the fixed leg) and the other pays an amount tied to the change in an inflation index (the inflation leg). Because no periodic coupons are exchanged, both legs settle as one lump sum at the end of the contract.

How it works

• Fixed leg: one party agrees to pay a fixed, predetermined rate on a reference notional.
• Inflation leg: the counterparty pays an amount based on the realized change in an agreed inflation index (e.g., CPI, RPI).
• Settlement: both payments are netted and settled once at maturity.
• Purpose: hedge or speculate on realized inflation versus market-implied inflation (the breakeven rate).

The party that pays the fixed rate is often called the fixed-rate payer; the party that receives the inflation-linked amount is the inflation receiver (or inflation buyer). If realized inflation exceeds the fixed rate (breakeven), the inflation receiver gains; if inflation is lower, the fixed-rate payer benefits.

Pricing formulas

Let:
– A = reference notional
– r = fixed annual rate (decimal)
– t = number of years to maturity
– IE = inflation index level at maturity
– IS = inflation index level at start

Fixed leg (amount paid by fixed-rate payer at maturity):
Fixed Leg = A × [(1 + r)^t − 1]

Inflation leg (amount paid by inflation payer at maturity):
Inflation Leg = A × [(IE / IS) − 1]

Net payment at maturity = Inflation Leg − Fixed Leg (paid from inflation payer to fixed-rate payer if negative, or vice versa).

Example

Two parties enter a 5-year ZCIS with notional A = $100,000,000 and fixed rate r = 2.4%:

• Fixed Leg = $100,000,000 × [(1.024)^5 − 1] = $12,589,990.68
• Suppose the inflation index rises by 25% over the period (IE / IS = 1.25):
  Inflation Leg = $100,000,000 × (1.25 − 1) = $25,000,000

Net result: the inflation-linked payer owes $25,000,000 while the fixed-rate payer would owe $12,589,990; net payment to the inflation receiver is $25,000,000 − $12,589,990 = $12,410,009.32. Because realized inflation (25% cumulative) exceeded the effective fixed return, the inflation receiver profits.

Key considerations

• Index selection and currency: the inflation index used depends on the swap currency (e.g., U.S. dollar swaps commonly reference CPI; U.K. swaps may reference RPI).
• Credit risk: ZCIS are OTC contracts and carry counterparty/default risk. Parties often post collateral or use clearing arrangements to mitigate this risk.
• Liquidity and trading: although settlements occur at maturity, swaps can be traded or closed out in the OTC market before maturity.
• Alternatives: other inflation-hedging instruments include TIPS, inflation-linked bonds, inflation-linked CDs, and other inflation swap structures (e.g., year-on-year swaps, real yield swaps).

Benefits

• Clear breakeven signal: the fixed rate reflects market-implied inflation expectations for the swap horizon.
• Simple settlement: single lump-sum payment simplifies cash flow management.
• Flexible hedging: tailored maturities and notionals for precise inflation exposure management without exchanging principal.

Breakeven inflation

The breakeven inflation rate is the fixed rate r at which the fixed leg equals the market expectation of the inflation leg; at that rate neither party expects a net gain. Market participants use ZCIS and related instruments to infer market inflation expectations over specific horizons.

Conclusion

A zero-coupon inflation swap is a straightforward, single-settlement tool to transfer or take on inflation risk. It provides a market-based measure of expected inflation and can be used alongside other inflation-linked instruments to hedge purchasing-power risk or position for inflation changes.