Inflation Swap Cash Flows Under Deflation

Summary

The document explains how deflation affects the floating inflation leg of an inflation swap relative to its fixed leg. It compares the arrangement with an interest rate swap: if realized inflation is negative, the floating return can be negative, so the party receiving inflation may owe money on that leg while also paying the fixed rate. In that case, the two cash flows work against that party at the same time.

The explanation applies to zero-coupon and year-on-year inflation swaps, where the floating payment is tied to the change in an inflation index. It also distinguishes inflation-linked bonds, which commonly include a zero-percent floor to limit deflation losses to principal. The note gives a conceptual comparison, not a contract-specific calculation; actual payment conventions and protections depend on the instrument terms.

Key ideas

• A negative inflation-index return can make the floating leg payable by the inflation receiver.
• The receiver may owe both the fixed payment and a payment associated with negative realized inflation.
• Inflation swaps resemble interest rate swaps when their floating reference return turns negative.
• Inflation-linked bonds may have a zero floor that protects against deflation.

Tags

# What happens to both sides of an inflation swap agreement if there is deflation?


# What happens to both sides of an inflation swap agreement if there is deflation?












If there is deflation does the Inflation receiver not only pay the fixed leg but also receives a reduced CPI?

I.e. does he lose twice?

## Answer by Peaceful (score 2)

https://quant.stackexchange.com/a/48758

sorry, I cannot comment yet as I have less than 50 reputation. So I will to have to put another answer here.

I think you are probably right. This is the same as you are paying fixed on a interest rate swap contract but the floating rate goes negative. In this case, in theory, you will have to pay both legs.

usually, for an inflation swap (either zero coupon swaps or year on year swaps), the quote on the fixed side is a rate and the payment of the floating side is the return rate of the inflation indices in a period, which makes inflation swap case similar to interest rate swap case discussed above.

For inflation linked bonds, there is usually a floor with strike set to zero to protect it from going deflation.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.