Title: Trading Activity and Price Transparency in the Inflation Swap Market
Abstract: 1. INTRODUCTION An inflation swap is a derivative transaction in which one party agrees to swap fixed payments for floating payments tied to the inflation rate, for a given notional amount and period of time. A buyer might therefore agree to pay a per annum rate of 2.47 percent on a $25 million notional amount for ten years in order to receive the rate of inflation for that same time period and amount. Inflation swaps are used by market participants to hedge inflation risk and to speculate on the course of inflation and by market observers more broadly to infer inflation expectations. Several recent studies have compared the inflation swap rate with breakeven inflation as calculated from Treasury inflation-protected securities (TIPS) and nominal Treasury bonds. (1) The two market-based measures of expected inflation should be equal in the absence of market frictions. In practice, inflation swap rates are almost always higher, with the spread exceeding 100 basis points during the recent financial crisis. Fleckenstein, Longstaff, and Lustig (forthcoming) attribute this differential to the mispricing of TIPS relative to nominal Treasury bonds, and not to inflation swaps. (2) In contrast, Christensen and Gillan (2011) argue that the differential comes from a liquidity premium in inflation swaps as well as a liquidity premium in TIPS. (3) While a recent study examines the liquidity of the TIPS market (Fleming and Krishnan 2012), there is virtually no evidence on the liquidity of the inflation swap market. Aside from past research on inflation swaps, the issues of liquidity and price transparency in derivatives markets more generally have taken on greater import given regulatory efforts under way to improve the transparency of over-the-counter derivatives markets. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act calls for the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission to promulgate rules that provide for the public availability of over-the-counter derivatives transaction data in real time. (4) To date, the lack of transaction data has impeded the understanding of how the inflation swap and other derivatives markets operate. In early 2010, the OTC Derivatives Supervisors Group (ODSG), an international body of supervisors with oversight of major over-the-counter derivatives dealers, called for greater post-trade transparency. In response, major derivatives dealers provided the ODSG with access to three months of over-the-counter derivatives transaction data to analyze the implications of enhanced transparency for financial stability. Fleming et al. (2012) examine the data from the interest rate derivatives market, focusing on the four most actively traded products: interest rate swaps, overnight indexed swaps, swaptions, and forward rate agreements. This article uses the same interest rate derivatives data set to examine trading activity and price transparency in the U.S. inflation swap market. Specifically, we analyze all electronically matched zero-coupon inflation swap trades involving a G14 dealer for a three-month period in 2010. The data source is MarkitSERV, the predominant trade-matching and post-trade processing platform for interest rate derivatives transactions. An analysis of such data can serve as a resource for policymakers considering public reporting and other regulatory initiatives for the derivatives markets and for market participants and observers more generally interested in the workings of the inflation swap market. We find that relatively few trades occur in the U.S. zero-coupon inflation swap market. Our reasonably comprehensive data set contains only 144 trades (just over two trades per day) over our June 1 to August 31, 2010, sample period. Daily notional trading volume is estimated to average $65 million. In the TIPS market, in comparison, an estimated $5.0 billion per day traded over the same period, on average. …
Publication Year: 2013
Publication Date: 2013-05-01
Language: en
Type: article
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Cited By Count: 10
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