Question: At time=0 company A enters an 3y interest rate swap with a bank, where A recieves floating and pays fixed. After 1y, at t=1, the inflation changes from 1% to 3% does this affect the MV of the swap?

Attempt: Since nominal rate = real rate + inflation and the nominal is fixed here in this interest rate swap, the real rate A pays will go down hence they are better off.

Attempt 2: If A were to enter an IRS at t=1 they would have to pay a higher fixed rate than they do in the IRS they entered at t=0 so they are better off.

Is this correct?

  • $\begingroup$ Yes, of course. When the inflation kicks in A starts receiving higher floating rate payments, while continuing to pay the small fixed rate that was agreed before inflation was foreseen. A has profited. When others want to enter a swap they have to pay a higher fixed rate, as you said. $\endgroup$ – noob2 Oct 23 '17 at 14:07
  • $\begingroup$ You could estimate the increase in market value as the PV of an annuity of 0.02, i.e. the difference between the prior and current estimated inflation. This is what the savings from having to pay a 2% lower fixed rate than the market for the remaining life of the swap is worth. $\endgroup$ – noob2 Oct 23 '17 at 15:46
  • $\begingroup$ No, interest rate swap valuations do not have any direct dependency on inflation. Of course inflation rate swaps do but interest rate swaps's valuations are dependent only upon the prevailing forecast interest rates and discount curve. Implicitly they depend upon inflation because central bankers often change interest rates to mitigate inflation deviations but this is indirect and there are many examples of published inflation numbers changing dramatically without any associated change in the swap curve, and therefore your IRS could have precisely the same value whatever the inflation rate. $\endgroup$ – Attack68 Nov 4 '17 at 20:10

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