# Understanding Inflation Swaps: Basics, Benefits, and Examples

> **Definition**
>
> An inflation swap is a contract where one party exchanges fixed cash flows for payments linked to an inflation index, such as the CPI, transferring inflation risk to the other party.

## What Is an Inflation Swap?

An inflation swap is a contract used to transfer [inflation risk](https://www.investopedia.com/terms/i/inflationrisk.asp) from one party to another through an exchange of fixed cash flows. These swaps are generally used by institutional investors, corporations, and governments as a hedge against inflation.

In an inflation swap, one party pays a fixed rate cash flow on a notional principal amount while the other party pays a floating rate linked to an inflation index, such as the [Consumer Price Index](https://www.investopedia.com/terms/c/consumerpriceindex.asp) (CPI).

The party paying the floating rate pays the inflation-adjusted rate multiplied by the [notional principal amount](https://www.investopedia.com/terms/n/notionalprincipalamount.asp). Usually, the principal does not change hands. Each cash flow comprises one leg of the swap.

### Key Takeaways

*   An inflation swap transfers inflation risk from one party to another through fixed and floating cash flow exchanges.
*   One party pays a fixed rate, while the other pays a floating rate linked to an inflation index like the CPI.
*   Inflation swaps are useful for financial professionals to hedge inflation risks and can highlight expected inflation rates.
*   Zero-coupon inflation swaps are common, where cash flows are exchanged only at maturity.
*   These swaps help estimate "break-even" inflation rates based on market demand and supply.

## Understanding the Mechanics of Inflation Swaps

Financial professionals use inflation swaps to [hedge](https://www.investopedia.com/terms/h/hedge.asp) inflation risk and benefit from price changes. Many types of institutions find inflation swaps to be valuable tools. Inflation payers are usually institutions whose main business involves receiving inflation cash flows. For instance, a utility company's income is often connected to [inflation](https://www.investopedia.com/terms/i/inflation.asp), either directly or indirectly.

One party to an inflation swap will receive a variable (floating) payment linked to an inflation rate and pay an amount based on a fixed rate of [interest](https://www.investopedia.com/terms/i/interest.asp), while the other party will pay that inflation rate-linked payment and receive the fixed interest rate payment. Notional amounts are used to calculate the payment streams. The most common are [zero-coupon swaps](https://www.investopedia.com/terms/z/zero-coupon-swap.asp), where cash flows are exchanged only at maturity.

Like other swaps, an inflation swap initially starts at [par](https://www.investopedia.com/terms/p/parvalue.asp), or face value. As interest and inflation rates change, the value of the swap's outstanding floating payments will change to be either positive or negative. At predetermined times, the market value of the swap is calculated. A [counterparty](https://www.investopedia.com/terms/c/counterparty.asp) will post collateral to the other party and vice versa, depending on the value of the swap.

## Advantages of Using Inflation Swaps

An inflation swap helps analysts estimate the "break-even" inflation rate from the market's perspective. Conceptually, it is very similar to the way that a market sets the price for any [commodity](https://www.investopedia.com/terms/c/commodity.asp), namely the agreement between a buyer and a seller (between demand and supply) to transact at a specified rate. In this case, the specified rate is the expected rate of inflation.

Simply put, the two parties agree based on their expectations of the inflation rate during the period. As with [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp), the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged), but instead of hedging against or speculating on [interest rate risk](https://www.investopedia.com/terms/i/interestraterisk.asp), their focus is solely on the inflation rate.

## How an Inflation Swap Works in Reality

An example of an inflation swap is when an investor buys [commercial paper](https://www.investopedia.com/terms/c/commercialpaper.asp). At the same time, the investor enters into an inflation swap contract, receiving a fixed rate and paying a floating rate linked to inflation.

By entering into an inflation swap, the investor effectively turns the inflation component of the commercial paper from floating to fixed. The commercial paper gives the investor real [LIBOR](https://www.investopedia.com/terms/l/libor.asp) plus [credit spread](https://www.investopedia.com/terms/c/creditspread.asp) and a floating inflation rate, which the investor exchanges for a fixed rate with a counterparty.

## The Bottom Line

Financial entities use inflation swaps to transfer inflation risk in exchange for cash flow. These entities use them as a hedge against inflation and to benefit from price fluctuations. Inflation swaps are conducted when financial institutions and other investors reach an agreement about the swap details and generally trade them over-the-counter.