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Inflation Derivatives Explained Markets, Products, and Pricing

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Inflation Derivatives Explained Markets, Products, and Pricing Fixed Income Quantitative Research July 2005 Inflation Derivatives Explained Markets, Products, and Pricing Jeroen Kerkhof • The inflation derivatives market has achieved critical mass, with an outstanding notional volume of over $100bn • Inflation derivatives make it possible to isolate inflation risk from interest rate risk • Zero-coupon inflation swaps dominate the market and form the building blocks for other inflation derivatives • Real returns, breakeven inflation and seasonality are explained • The mechanics, risks and uses of inflation derivatives are discussed • ISDA 2005 inflation definitions are outlined Lehman Brothers | Inflation Derivatives Explained CONTENTS 1. Introduction 3 2. The Markets 5 2.1. Growth and size........................................................................................................... 5 2.2. Market breadth.............................................................................................................6 2.3. Market participants...................................................................................................... 6 2.4. Products overview ....................................................................................................... 8 3. Inflation Indices 9 3.1. Euro area...................................................................................................................... 9 3.2. France........................................................................................................................ 10 3.3. United Kingdom ........................................................................................................ 11 3.4. United States..............................................................................................................11 3.5. Other indices..............................................................................................................12 3.6. Seasonality in inflation indices.................................................................................. 12 4. Inflation Basics and Concepts 16 4.1. Inflation, nominal value and real value ..................................................................... 16 4.2. Inflation-linked cashflows and real bonds................................................................. 16 4.3. Indices, indexation lags and announcements............................................................. 19 4.4. Breakeven inflation ................................................................................................... 21 4.5. Components of breakeven inflation rate.................................................................... 23 5. Zero-coupon Inflation Swaps 25 6. Inflation Analysis Framework 29 6.1. Constructing an inflation curve ................................................................................. 29 6.2. Inflation and interest rate risk.................................................................................... 34 6.3. Counterparty risk....................................................................................................... 36 6.4. Rounding risk ............................................................................................................ 38 6.5. Seasonality risk.......................................................................................................... 38 6.6. Institutional risk.........................................................................................................40 7. Inflation Swaps and Futures 41 7.1. Revenue inflation swap ............................................................................................. 42 7.2. OTC inflation bond.................................................................................................... 43 7.3. Period-on-period inflation swaps............................................................................... 43 7.4. Inflation asset swaps.................................................................................................. 45 7.5. Inflation futures ......................................................................................................... 49 July 2005 Please see important analyst certification(s) on the back page of this report 1 Lehman Brothers | Inflation Derivatives Explained 8. Inflation Volatility Products 52 8.1. Inflation caps and floors ............................................................................................ 52 8.2. Inflation swaptions .................................................................................................... 53 8.3. LPI swaps ..................................................................................................................56 8.4. Inflation spread options ............................................................................................. 57 9. Structured Inflation Products 59 9.1. Total return swaps ..................................................................................................... 59 9.2. Inflation-linked equity............................................................................................... 61 9.3. Inflation-linked equity options .................................................................................. 61 9.4. Inflation-linked credit default swaps ......................................................................... 62 9.5. Inflation-linked CDO................................................................................................. 64 10. Legal, Regulatory, and Accounting Issues 66 10.1. ISDA inflation derivatives documentation .............................................................. 66 10.2. Regulation for pension funds................................................................................... 67 10.3. Accounting standards .............................................................................................. 67 Appendix 69 A.1. Calculating inflation asset swap spreads .................................................................. 69 A.2. Estimation of seasonal patterns ................................................................................ 70 A.3. Duration and convexity analysis............................................................................... 71 A.4. Valuation of forward starting zero-coupon swaps .................................................... 72 A.5. Valuation of inflation caps and floors....................................................................... 73 A.6. Valuation of spread options and inflation-linked equity options.............................. 73 A.7. Valuation of inflation swaptions............................................................................... 74 References 75 Glossary 76 Summary of Notation and Definitions 79 July 2005 2 Lehman Brothers | Inflation Derivatives Explained 1. INTRODUCTION1 Jeroen Kerkhof In recent years the market for inflation-linked derivative securities has experienced +44 (0)20 7102 3981 considerable growth. From almost non-existent in early 2001, it has grown to about [email protected] €50bn notional traded through the broker market in 2004, double the notional traded through the broker market in 2003. Rapid growth is expected to continue for the coming years. So far the growth has mainly been driven by the European market, but recently interest in the US market has picked up as well. The purpose of inflation The primary purpose of inflation derivatives is the transfer of inflation risk. For example, derivatives is the transfer of real estate companies may want to shed some of their natural exposure to inflation risk, inflation risk while pension funds may want to cover their natural liabilities to this risk. In their simplest form, inflation derivatives provide an efficient way to transfer inflation risk. But their flexibility also allows them to replicate in derivative form the inflation risks embedded in other instruments such as standard cash instruments (that is, inflation- linked bonds). For example, as we will see later, an inflation swap can be theoretically replicated using a portfolio of a zero-coupon inflation-linked bond and a zero-coupon nominal bond. Inflation derivatives allow As is the case for the nominal interest rate market, the advantage of inflation derivative for tailor-made solutions contracts over inflation bonds is that derivatives can be tailored to fit particular client demand more precisely than bonds. With the introduction of unfunded inflation-linked products, inflation derivatives have for the first time separated the issue of funding from inflation risk. This has made inflation markets more accessible to parties with high funding costs and made it cheaper to leverage inflation risk. For instance, hedge funds are increasingly involved in inflation markets. Our focus is on explaining Before any participant enters the inflation derivatives market, a solid understanding of the mechanics, risk and the mechanics, risks and valuation of inflation derivatives is essential. The aim of this valuation of inflation report is to provide this understanding. We hope that readers will gain the necessary derivatives comfort and understanding to take advantage of the new opportunities that the inflation derivatives market presents. This report is structured as follows. Chapter 2 introduces the reader to the inflation market by presenting an overview of the market’s growth, products and participants. It explains how the market developed and helps readers understand the likely future evolution of the inflation-linked
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