Inflation risk

Over the past couple of years, the inflation-linked (or linker) market has undergone dramatic growth and development. Issuance of inflation-linked bonds has increased substantially, but it’s in the area of inflation-linked derivatives that the pace of progress has been most marked.

Bankers involved in the area say trading volumes of inflation-linked derivatives – not just swaps but also floors, caps, swaptions and, increasingly, hybrid structures that may incorporate an equity component – have multiplied by at least 10 times in little more than 18 months.

It’s no great surprise that inflation-linked derivatives are enjoying such popularity, given the increased flexibility they offer in terms of structure and the lower cost compared with the traditional route of issuing inflation-linked bonds. Neither should it come as a surprise that most major derivatives houses are scrambling to capture business in what is a pretty lucrative market.

As we outline in this special report, however, the market is still in its infancy and faces a number of challenges to its future growth.

Floors remain the dominant form of option in the market, and bankers are hopeful that the recent surge in primary issuance will allow other products to develop further. But while clients seem to want more complex options, including hybrids, bankers are concerned about their ability to model the risks involved.

Meanwhile, the proposed International Financial Reporting Standards rule, which would prohibit the use of synthetic instrument accounting, could feasibly scupper the market in its infancy.