How do zero-coupon and year-over-year inflation swaps hedge CPI exposure?

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AcadiFi · Accepted Answer

Inflation swaps exchange fixed payments for inflation-linked payments referencing a price index (CPI-U in the US, HICP ex-tobacco in the Eurozone). Two main structures exist. **Zero-Coupon Inflation Swap (ZCIS)**: one payment at maturity. Fixed payer pays (1 + k)^T − 1; inflation payer pays (CPI_T / CPI_0) − 1. Used by pension funds to hedge terminal real liabilities. Example: Halstrom Regional Pension has a $50M liability in 10 years that must be inflation-adjusted. They enter a 10Y ZCIS at a fixed rate of 2.40%. At maturity, if cumulative CPI growth is 28%, inflation payer owes 0.28 × $50M = $14M, fixed payer owes ((1.024)^10 − 1) × $50M = 26.8% × $50M = $13.4M. Net: pension receives $0.6M. **Year-over-Year (YoY)**: annual exchanges on each anniversary. Fixed leg pays k × notional; inflation leg pays (CPI_t / CPI_{t−1} − 1) × notional. Useful for utilities with annual revenue indexing. ```mermaid flowchart LR A[Pension
Infl Receiver] -->|2.40% Annual Comp| B[Dealer] B -->|CPI T / CPI 0 -1| A A -.Hedges.-> C[Real Liability] ``` The breakeven inflation rate from these swaps (or from TIPS-nominal spreads) reflects expected CPI plus an inflation risk premium. FRM candidates should distinguish breakeven from expected inflation and understand seasonality adjustments (CPI has strong January and summer patterns that affect short-dated swaps).

How do zero-coupon and year-over-year inflation swaps hedge CPI exposure?

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