With the fear of inflation creeping into the minds of investors, it will be prudent to protect one from the severe consequence of inflation. In this regard, inflation linked products may provide some respite to the worried investors.

The demand for inflation linked instruments and derivatives have grown significantly in recent times. Most rapidly growing derivatives product in the world are not the credit derivatives, but inflation derivatives. Barclays Capital of UK is the most dominant player in this derivative market since it conducted the first transaction in inflation derivatives in 1994. Due to the active participation of investors and bankers, the market for inflation derivative products has grown amazingly, particularly in Europe. In the past one and a half years, the face value of the Barclays Capital Euro Inflation-Linked Bond (ILB) Index has doubled to 50 bn. The inflation derivatives market is relatively young; the UK Government was the first to issue inflation-linked bonds in 1982, while the US Government began issuing them only in 1997. However, US market is also growing rapidly. Recently US market has shown more transactions in these products than in Europe.

Inflation is defined as the percentage increase or decrease in Consumer Price Indices (CPI) or Retail Price Indices (RPI) with respect to those indices on the same period in the previous year. These indices are constructed from the price of a basket of goods and services taken to be the representative of the consumption patterns of the households in a country, and are published weekly or monthly by the national statistics institutes. Recent economic developments have indicated that neither equity nor gold have been effective in protecting against purchasing power erosion. Due to the slump in the stock markets around the world, gold and equity are not able to provide a reasonable hedge against inflation. Consequently, it has been observed that interest rates have lost their connection with inflation rates. This has resulted in heightened awareness among consumers, investors and insures that their inflation exposures are required to be hedged against some inflation related instruments. As a result, inflation has started trading as a separate asset class distinct to interest rates and equities. Therefore, it can be said that in the backdrop of tremendous growth in the inflation-linked instruments and derivatives market has been the growing awareness of inflation risk.

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