Parameta Logo
parameta logo
Inflation and Interest Rates

What is a breakeven inflation swap index?

Ellie Edwards
By Ellie Edwards, Content and PR LeadSep 26, 2024

A breakeven inflation swap index (BIS) is a financial index that measures the market's expectation of future inflation. It is derived from the difference between the yields of two bonds: a nominal bond and an inflation-linked bond. 

How it works: 

  1. Nominal Bond: A bond that pays a fixed interest rate. 

  2. Inflation-Linked Bond: A bond whose principal and interest payments are adjusted for inflation. 

  3. Yield Difference: The difference between the yields of these two bonds represents the market's expectation of future inflation. If investors expect higher inflation, they will demand a higher yield on the nominal bond to compensate for the eroding purchasing power of their fixed interest payments. 

Why it's important: 

  • Inflation Expectations: BIS provides a valuable indicator of inflation expectations, which can influence investment decisions, monetary policy, and economic forecasting. 

  • Risk Management: Investors can use BIS to manage inflation risk in their portfolios. 

  • Policy Analysis: Central banks and policymakers can use BIS to assess the effectiveness of their monetary policies and to anticipate potential inflationary pressures. 

Breakeven inflation swaps serve multiple purposes, primarily related to managing and understanding inflation risk: 

  1. Inflation Hedging: Investors can use BIS to hedge their portfolios against inflation risk. By entering into a BIS, they can effectively lock in a future inflation rate, protecting their investments from the eroding purchasing power of inflation. 

  2. Inflation Expectations: BIS provides a valuable indicator of market-implied inflation expectations. This information can be used by investors, policymakers, and analysts to assess the likelihood of future inflation and make informed decisions. 

  3. Policy Analysis: Central banks and policymakers can use BIS to gauge the effectiveness of their monetary policies and to anticipate potential inflationary pressures. By understanding market expectations, they can make informed decisions about interest rate adjustments and other policy measures. 

  4. Investment Decision Making: Investors can use BIS to evaluate the attractiveness of different investment options. For example, if BIS suggests that inflation expectations are rising, investors may prefer to invest in assets that are expected to appreciate in value with inflation, such as real estate or commodities. 

  5. Derivative Pricing: BIS can be used as a benchmark for pricing other inflation-linked derivatives, such as inflation-linked bonds and options. 

Breakeven inflation swap index (BIS) is calculated by subtracting the yield of an inflation-linked bond from the yield of a nominal bond. 

Here's a breakdown of the steps: 

  1. Yield of Nominal Bond: Determine the yield of a nominal bond, which pays a fixed interest rate. 

  2. Yield of Inflation-Linked Bond: Determine the yield of an inflation-linked bond, whose principal and interest payments are adjusted for inflation. 

  3. Calculate Difference: Subtract the yield of the inflation-linked bond from the yield of the nominal bond. 

The resulting difference represents the market's expectation of future inflation. If the yield of the nominal bond is higher than the yield of the inflation-linked bond, it suggests that the market expects inflation to rise in the future. Conversely, if the yield of the inflation-linked bond is higher, it suggests that the market expects inflation to remain low or decline. 

Benefits of Breakeven Inflation Swap Index (BIS) BIS offers several advantages for investors, policymakers, and analysts: 

  1. Inflation Hedging: 

    • Protection against inflation: BIS allows investors to hedge their portfolios against inflation risk, ensuring that their investments maintain purchasing power. 

    • Risk management: By using BIS, investors can effectively manage the impact of inflation on their investments. 

  2. Inflation Expectations: 

    • Market-implied expectations: BIS provides a valuable indicator of market-implied inflation expectations. 

    • Decision-making: This information can be used to make informed investment decisions and assess the effectiveness of monetary policies. 

  3. Policy Analysis: 

    • Monetary policy assessment: BIS helps policymakers gauge the effectiveness of their monetary policies and anticipate potential inflationary pressures. 

    • Policy adjustments: This information can be used to make informed decisions about interest rate adjustments and other policy measures. 

  4. Investment Decision Making: 

    • Asset allocation: BIS can be used to evaluate the attractiveness of different investment options based on inflation expectations. 

    • Risk-return analysis: Investors can use BIS to assess the risk-return trade-offs of various investments. 

  5. Derivative Pricing:

    • Benchmark for pricing: BIS serves as a benchmark for pricing other inflation-linked derivatives, such as inflation-linked bonds and options. 

Read the EUX factsheet

© 2024 ICAP Information Services Limited (“IISL”). This communication is provided by ICAP Information Services Limited or a member of its group (“Parameta”) and all information contained in or attached hereto (the “Information”) is for information purposes only and is confidential. Access to the Information by anyone other than the intended recipient is unauthorised without Parameta’s prior written approval. The Information may not be not used or disclosed for any purpose without Parameta’s prior written approval, including without limitation, storing, copying, distributing, licensing, selling or displaying the Information, using the Information in an application or to create derived data of any kind, co-mingling the Information with any other data or using the data for any unlawful purpose of for any purpose that would cause it to become a benchmark under any law, regulation or guidance.

The Information is not, and should not be construed as, a live price, an offer, bid, recommendation or solicitation in relation to any financial instrument or investment or to participate in any particular trading strategy or constituting financial or investment advice or a financial promotion. The Information is not to be relied upon for any purpose whatsoever and is provided “as is” without warranty of any kind, either expressly or by implication, including without limitation as to completeness, timeliness, accuracy, continuity, merchantability or fitness for any particular purpose. All representations and warranties are expressly disclaimed, to the fullest extent possible under applicable law. In no circumstances will Parameta be liable for any indirect or direct loss, or consequential loss or damages including without limitation, loss of business or profits arising from the use of, any inability to use, or any inaccuracy in the Information. Parameta may suspend, withdraw or modify or change the terms of the provision of the Information at any time in its sole discretion, without notice.

All rights, including without limitation intellectual property rights, in and to the Information are, and shall remain, the property of IISL or its licensors. Use of, access to or delivery of Parameta’s products and/or services requires a prior written licence from Parameta or its relevant affiliates. The terms of this disclaimer are governed by the laws of England and Wales.

image