An inflation -indexed swap which is established on the same notional principal amount for both legs, but with different payout profiles. The floating leg is index-linked and compounds its payments with the rate of change of a specific inflation index. The fixed leg compounds its payments at a preset fixed rate. This swap is typically used to hedge inflation-linked cash flows including project finance cash flows, rental streams, lease payments, etc.
It helps market participants who pay or receive such cash flows to eliminate the future uncertainty associated with fixed-growth cash flows. The fixed rate provides a reference point against which expected future rates of inflation can be compared.
For example, if a bank is offering a fixed rate of 3.5% for such a swap, and an investor expects that inflation rates would exceed 3.5% over the life of the swap, the investor may choose to receive fixed payments and pay inflation-linked on this swap.
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