Inflation risk

Where It Matters

Inflation risk sits outside the standard IRRBB taxonomy — it is not gap risk, basis risk, or option risk — but it is a real market risk that can arise in the banking book wherever inflation-linked instruments are held. Common sources include: linker portfolios held as part of HQLA or liquidity buffers, inflation swaps used to hedge pension obligations (typically pension risk not banking book risk) or structured product liabilities, and index-linked gilts held in securities portfolios.

Modelling complexity: inflation-linked instruments require additional cashflow modelling attributes over and above a standard bond. The cashflows are not fixed — they depend on the evolution of the inflation index, which must be projected forward using an inflation curve rather than simply applying a coupon schedule. Specifically, the index ratio is required to project the amortisation of the principal: the index ratio is the ratio of the current inflation index level to the base index level at issuance, and it is applied to the notional to derive the inflation-adjusted principal and coupon at each payment date. Without this attribute captured in the cashflow model, the projected cashflows will be wrong regardless of the rate scenario applied. This means the instrument cannot be fed into a standard IRRBB cashflow model without specific inflation indexation logic. Where inflation-linked positions are small relative to the overall book, this modelling complexity is sometimes not built out, and the instruments are either excluded from the model entirely, approximated as fixed rate equivalents, or held as static notionals. Each of these workarounds introduces modelling error that, while potentially immaterial individually, should be periodically assessed as the portfolio size changes.

A further modelling choice that needs to be explicitly decided: when running interest rate shock scenarios, should inflation be shocked in line with rates or held flat? The two approaches produce materially different results for inflation-linked positions. If inflation is shocked alongside rates — on the basis that a rate rise typically reflects or causes higher inflation — the indexed cashflows increase, partially or fully offsetting the discount rate effect on the linker's present value. If inflation is held flat and only rates are shocked, the instrument behaves more like a conventional fixed rate bond and shows full PVBP-style sensitivity. Neither assumption is universally correct: the right choice depends on the scenario being modelled and the economic logic behind it. The important thing is that the choice is made explicitly, documented, applied consistently across all inflation-linked positions, and stress-tested under both assumptions so the sensitivity to the modelling choice itself is understood.

The interaction with interest rate risk: inflation-linked instruments also have interest rate sensitivity through their real yield component. A linker's price is driven by both the real yield (which behaves like a conventional bond yield) and the inflation expectation embedded in the breakeven rate. A shock to nominal rates can therefore move a linker through both channels simultaneously — the real yield component and the inflation expectation component — making the combined sensitivity harder to measure and hedge than a conventional fixed rate bond.

Hedging: inflation exposure can be hedged using inflation swaps (paying the inflation leg, receiving fixed or floating). However, basis risk can arise between the inflation index used in the asset (e.g. RPI) and the index available in the swap market (e.g. CPI), particularly following the RPI reform in the UK. This index mismatch can leave a residual inflation exposure even in a nominally hedged position and should be explicitly monitored.