What is the main function of inflation swaps?

What is the main function of inflation swaps?

• A. Exchange fixed interest rates only
• B. Exchange cash flows tied to an inflation index
• C. Swap currencies based on inflation rates
• D. Exchange total returns on equities

Answer: (B)

The main function of inflation swaps is to exchange cash flows tied to an inflation index. In an inflation swap, one party typically agrees to pay a cash flow that is linked to a specific inflation index (such as the Consumer Price Index) while receiving a fixed rate of return in return. This allows participants to hedge against inflation risk—the potential for rising prices that can erode purchasing power. This mechanism is particularly valuable for investors or institutions that want to protect their portfolios from the impact of inflation on future cash flows. By participating in an inflation swap, they can ensure that their returns adjust with inflation, thereby maintaining their real purchasing power. The other options do not accurately capture the primary function of inflation swaps: exchanging fixed interest rates pertains to standard interest rate swaps, currency swaps focus on exchanging cash flows based on different currencies, and total returns on equities involve stock performance without direct ties to inflation indices.

The main function of inflation swaps is to exchange cash flows tied to an inflation index. In an inflation swap, one party typically agrees to pay a cash flow that is linked to a specific inflation index (such as the Consumer Price Index) while receiving a fixed rate of return in return. This allows participants to hedge against inflation risk—the potential for rising prices that can erode purchasing power.

This mechanism is particularly valuable for investors or institutions that want to protect their portfolios from the impact of inflation on future cash flows. By participating in an inflation swap, they can ensure that their returns adjust with inflation, thereby maintaining their real purchasing power.

The other options do not accurately capture the primary function of inflation swaps: exchanging fixed interest rates pertains to standard interest rate swaps, currency swaps focus on exchanging cash flows based on different currencies, and total returns on equities involve stock performance without direct ties to inflation indices.