An Inflation Swap is a transaction where one party transfers inflation risk to a counterparty in exchange for a fixed payment. An inflation swap can provide a pretty accurate estimation of what would be considered the "break-even" inflation rate - the level of future inflation at which both parties to the swap are indifferent. In other words, it's like betting on the future direction of interest rates.For example, let's say you think that over the next five years, average annual inflation will be 3%. You could enter into an agreement with another party whereby you pay them a fixed amount each year for five years, and in return they pay you an amount equal to 3% of whatever CPI turns out to be during that year. If CPI ends up being exactly 3% each year, then both parties will have been paid what they expected and neither party will have made or lost anything. But if CPI turns out to be higher or lower than 3%, then one party will have made money at the expense of the other.
