How does a year-on-year inflation swap work?

Question

AcadiFi · Accepted Answer

A year-on-year (YoY) inflation swap pays, each period, the realized inflation rate over that period against a fixed inflation rate. Over an N-year swap there are N separate inflation exchanges.

Cedarbrook Pension enters a 5-year YoY swap paying 2.45% fixed annually, receiving realized CPI YoY on $25M. If year 1 CPI prints 3.10%, net receipt = (0.0310 - 0.0245) × $25M = $162,500. Each subsequent year settles independently.

Contrast with zero-coupon (ZC) inflation swap which has a single terminal payment: receiver gets (1 + realized CPI)^N - 1 × notional against fixed leg (1 + swap rate)^N - 1 × notional. ZC is simpler and more liquid; YoY is favored by liability hedgers who need annual cash flows.

Pricing the YoY swap requires modeling not just expected inflation but also the convexity term because expected (1 + π_t) × (1 + π_{t+1}) does not equal product of expectations. The YoY inflation swap rate is approximately ZC annualized rate minus convexity adjustment of 0.5 × σ_π² × correlation term.

Liquidity is deepest in EUR HICP and UK RPI, narrower in USD CPI. Dealers hedge using TIPS versus nominal Treasuries plus inflation options for convexity.

How does a year-on-year inflation swap work?

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