A total return swap which has inflation total return as underlying. It entails the exchange of inflation total return for a floating rate adjusted with a certain spread (say LIBOR ± spread). This swap is primarily used to financially mimic the performance (price change and return) of an inflation-linked bond or a set of instruments. The inflation-rate payer counterparty pays the inflation total return over resetting periods multiplied by the notional amount, whilst the floating-rate payer counterparty pays (LIBOR ± spread) multiplied by the notional amount.
This swap allows an investor to take a view on an inflation exposure, resulting, for example, from holding inflation bonds or similar instruments without actually holding the bonds or instruments. If interest rates move up, driving bond prices down during the resetting period, the buyer of the swap (long inflation) will be worse off if the price fall exceeds, in effect, the coupon amount. In such case, the buyer pays both the total return and the floating rate (since the total return is negative). In the opposite case, when bond prices go up, the buyer receives the inflation total return.
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