An inflation derivative (cap) that pays out if inflation (as measured by percentage increase in the consumer price index) exceeds a certain level (threshold) over a specified period of time. For example, a 3-year inflation cap with a strike price of 4% pays the buyer the rate of inflation (the increase in inflation) on a notional amount during any of the next three years which prices rise on average. The inflation cap is, so to speak, a deflation floor.

However, since official publication of CPI figures is carried out at a date later than the end of the period in question, the payout would have to be delayed to that date. The effective payout, then, differs from the “nominal” payout, as set out in the below two equations:

let a, b denote the start and end of a cap’s life, L denote the notional amount, and K refer to the strike, then:

Nominal payout @ b = L x max [((C_b / C_a) – 1) – K, 0]

C_a and C_b : consumer price index readings at (a) and (b) respectively.

Effective payout @ b = L x P_bd max [((C_b / C_a) – 1) – K, 0]

where:
d denotes the later date at which inflation figures are effectively released
P_bd denotes inflation adjustment within the period between the end of a cap’s life and the actual release of inflation data.

The inflation cap is also known as an inflation-indexed cap.