A firm with inflation-linked assets or revenue, such as a utility, uses an inflation swap to protect against moves in prices. Which pair gives the side such a firm actually takes and its purpose?
Quiz: Inflation Derivatives
Last reviewed: September 25, 2026
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5 questions to check your understanding of the chapter “Inflation Derivatives”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.
Question 1
Answer and explanation
Answer: D
A firm with inflation-linked revenue pays the inflation leg and receives the fixed leg. It is protecting against a shortfall in revenue if prices do not rise. If prices do not rise, its revenue grows less, but it receives the difference on the swap, which makes up for the shortfall. If prices rise sharply, its revenue grows, but the swap payment cancels out that extra revenue.
Receiving the inflation leg to protect against prices rising is what pension funds and insurers that must make inflation-linked payments do. They are protecting against the higher cost of those payments when prices rise. A party that pays the inflation leg pays more on the swap when prices rise, so it is not protected against prices rising. A party that receives the inflation leg pays the difference if average inflation over the term is below the fixed rate, so it is not protected against prices not rising.
Learn more: Inflation Swaps
Question 2
As a hypothetical example, an investor holds 5 billion yen in face value of Japanese inflation-indexed JGBs issued in fiscal 2013 or later. The coupon rate is 0.2% a year, and interest is paid twice a year, with each payment covering half a year. If the indexation coefficient at maturity is 0.96, which pair gives the redemption amount and the final interest payment?
Answer and explanation
Answer: A
The redemption amount is 5 billion yen, and the final interest payment is 4.8 million yen. Inflation-indexed JGBs issued from fiscal 2013 onward have a floor on the principal at maturity, which the Ministry of Finance calls the deflation floor. If the indexation coefficient at maturity is below 1, they are redeemed at face value rather than at the inflation-adjusted principal amount. The deflation floor applies only to the principal repaid at maturity, not to interest. The final interest payment is based on the inflation-adjusted principal found with the indexation coefficient of 0.96: 5 billion yen × 0.96 = 4.8 billion yen. The interest is 4.8 billion yen × 0.2% × 1/2 = 4.8 million yen.
The two choices with a final interest payment of 5 million yen assume that interest also has a floor. The two choices with a redemption amount of 4.8 billion yen give the redemption amount of the issues up to fiscal 2008 (the old type), which have no deflation floor.
Suppose instead that the indexation coefficient at maturity had risen to 1.05. The inflation-adjusted principal would be 5.25 billion yen, and the redemption amount would also be 5.25 billion yen. The final interest payment would be 5.25 billion yen × 0.2% × 1/2 = 5.25 million yen.
Learn more: Inflation-Indexed JGBs and BEI
Question 3
As a hypothetical example, an inflation-indexed JGB with 10 years to maturity has a breakeven inflation rate (BEI) of 1.0% and a nominal rate for the same maturity of 1.5%, and its price is 95.18 yen per 100 yen of current inflation-adjusted principal amount. Ignore interest, and assume that prices rise at the BEI until maturity. Which of the following moves lowers the price of this inflation-indexed JGB?
Answer and explanation
Answer: B
The price falls when only the nominal rate rises. The price is the principal grown at the BEI until maturity, discounted at the nominal rate. If only the nominal rate rises by 50bp to 2.0%, the discount rate is higher, so the price falls to 90.62 yen.
If only the BEI rises by 50bp to 1.5%, the principal expected at maturity is larger, so the price rises to 100.00 yen. If only the nominal rate falls, the discount rate is lower, so the price rises. If the BEI and the nominal rate both rise by 50bp, the two effects almost cancel out, and the price is 95.20 yen, hardly changed. An investor holding an inflation-indexed JGB gains when the BEI rises, and loses when the BEI falls or the nominal rate rises.
Learn more: Inflation-Indexed JGBs and BEI
Question 4
A May 2013 paper from the Federal Reserve Bank of New York showed which period's inflation as the basis for the payments in US inflation swaps?
Answer and explanation
Answer: C
US trades base payments on inflation from three months before the start date to three months before the maturity date. A price index is published only after the month has ended, and the US consumer price index (CPI) for a month is not known until the middle of the following month. For this reason, the swap uses the index for an earlier month rather than prices on the start date or the maturity date. This delay is called the indexation lag.
"From the start date to the maturity date" ignores the publication delay. Prices on the maturity date are not yet known on that day, so the payment could not be set at maturity. The two choices that shift only one end of the period by three months compare two index values from mismatched points in time. Both the start and the end are shifted by the same three months.
Learn more: Inflation Swaps
Question 5
As a hypothetical example, a company buys a zero-coupon inflation cap (a form that pays once, at maturity) with a notional amount of 5 billion yen, a term of 2 years, and a strike of 2% a year. The price index at the start was 100, and the index referenced at maturity 2 years later was 110. Ignoring the premium, how much does the company receive at maturity?
Answer and explanation
Answer: B
The payment at maturity is 298 million yen. In this form of cap, the notional amount is multiplied by the positive part of the difference between the ratio of the index change and the strike compounded. The compounded strike is 1.02 × 1.02 = 1.0404, and the ratio of the index change is 110 ÷ 100 = 1.10. The difference is 1.10 − 1.0404 = 0.0596, so 5 billion yen × 0.0596 = 298 million yen.
500 million yen applies the 10% rise in the index without reflecting the strike: 5 billion yen × 10%. The 300 million yen choice does not compound the strike, treating it as 2% × 2 years = 4% and taking 5 billion yen × (10% − 4%). The 202 million yen choice is only the compounded-strike portion, 5 billion yen × 0.0404, and has nothing to do with the index change.
Suppose the index at maturity had risen only to 103. The ratio of 1.03 does not reach 1.0404, so there is no payment, and the buyer's cost is only the premium.
Learn more: Inflation Caps and Floors