In recent years the market for inflation-linked derivative securities has experienced considerable growth. From almost non-existent in early 2001, it has grown to about €50bn notional traded through the broker market in 2004, double the notional traded through the broker market in 2003. Rapid growth is expected to continue for the coming years. So far the growth has mainly been driven by the European market, but recently interest in the US market has picked up as well. The primary purpose of inflation derivatives is the transfer of inflation risk. For example, real estate companies may want to shed some of their natural exposure to inflation risk, while pension funds may want to cover their natural liabilities to this risk.
In their simplest form, inflation derivatives provide an efficient way to transfer inflation risk. But their flexibility also allows them to replicate in derivative form the inflation risks embedded in other instruments such as standard cash instruments (that is, inflationlinked bonds). For example, as we will see later, an inflation swap can be theoretically replicated using a portfolio of a zero-coupon inflation-linked bond and a zero-coupon nominal bond.
In their simplest form, inflation derivatives provide an efficient way to transfer inflation risk. But their flexibility also allows them to replicate in derivative form the inflation risks embedded in other instruments such as standard cash instruments (that is, inflationlinked bonds). For example, as we will see later, an inflation swap can be theoretically replicated using a portfolio of a zero-coupon inflation-linked bond and a zero-coupon nominal bond.