1. How do you price a Revenue Swap?
A revenue swap is priced with reference to a series of Zero Coupon Swaps with maturities corresponding to the payment dates of the revenue swap. The inflation legs of the Revenue Swap and the series of ZC swaps will be the same, so all that is needed to determine the fixed rate of the Revenue Swap is to match the PV of the fixed cashflows from the Revenue Swap and those of the series of ZC swaps.
2. How do you calculate seasonality adjustments?
There are a range of methods for doing this using historical data, but the problem is always the choice of the data set to be used. The old X11 approach provides a robust answer and involves taking a series of moving averages. A one year moving average of monthly points to establish the trend and then a shorter dated weighted moving average, typically over 5 months, of the difference between each data point and the trend.
The thinking behind this approach is that the trend is the non-seasonal component of the data and the difference between the trend and each data point contains seasonal information and noise. The noise is screened out by the second weighted moving average leaving only the seasonal component.
3. Are Par or Proceeds asset swaps more relevant for index linked bonds?
The problem with a Par Asset Swap is that, for a highly priced bond there needs to be a large upfront payment to cover the difference between the bond’s market price and par. This payment will require funding. The other issue is the “residual swap risk” that results from a potential default on the bond which leaves the offsetting swap cashflows in place. The higher the coupon on the bond the greater this risk. A Par Asset Swap suffers from both of these potential problems, while a Proceeds Asset Swap only has the residual swap risk, which is small for a high quality bond. As a result Proceeds Asset Swaps are often created from Index Linked Bonds.
4. Why is the lag on UK RPI swaps only 2-months whereas the lag on other swaps is generally 3-months, in line with the standard lag in index linked bonds?
A good question and one which I don’t have a clear answer for apart from to say this is just the way the market has developed. Further details on all of these points (possibly apart from the last) will be available as part of the Inflation Derivatives and Index Linked Bonds Course on 28 November 2024.
