Inflation(index)-Linked Asset Swap
What drives PnL of an inflation linked-bond-asset swap?
How do you price it or valuate it or model it?
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I'm not an expert in fixed income derivatives. However, a swap contract typically has 2 legs. In this case, the first is likely an Inflation index. The second is probably fixed rate (or may be another index or another floating rate). The valuation for a swap contract is based on difference in present value: PV(leg1)-PV(leg2).
2 components typically this is a TIPS bond vs the standard libor swap curve....so you have the TIPS (treasury bond where principle adjusted by CPI inflation) and then the treasury to libor swap spread
Works pretty much the same outside the US....but the US is the standard.
The principal value of TIPS rises as inflation rises while the interest payment varies with the adjusted principal value of the bond (the coupon % may be fixed...but its a % of Principle...which floats with CPI).
So if you are long the TIPS bond, then you would pay fixed / receive floating on the swap to be in an asset swap position . TIPS (also called "real rates") trade on spread to regular treasuries (called "nominals").
So, you can break the position down into 2 components 1) TIPS spread to Nominals 2) Nominals spread to swaps
Most common, the Nominal spread to swaps is the more liquid of the 2...so you can hedge that easily with any swaps desk. TIPS can be illiquid (to a degree)...especially if you are trading large size.
so, to clarify...the PnL is drivn by 2 components
1) TIPS vs Nominals spread 2) Nominals vs libor swap curve spread
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