Inflation floors, structured as options on the consumer price index for all urban consumers, are similar to insurance. The buyer of the contract pays a premium at the outset in return for the right to receive a payment after 10 years should the CPI decline during this period, according to D'Arcy Miell, global head of inflation products at BGC Partners LP, a New York-based inter-dealer broker.
The size of the payment would be calculated by multiplying the cumulative percentage decline in the consumer price index with the face value or 'notional' amount of the contracts, said Mark Greenwood, head of inflation options in the London office of Royal Bank of Scotland Group Plc.
Pimco's Wager
In Pimco's case, a cumulative 10% decline in the price index over 10 years would require the funds to pay out a total of about $810 million, based on that formula. The funds would pay nothing to the counterparties and keep the premiums if prices in 2020 are equal to or higher than in December 2009 or January 2010, depending on the contracts.
"This is obviously a very low-frequency, high-severity event," Greenwood said. "Investors fear deflation, but most ascribe a low probability to it."
Worah said Pimco's inflation floors are "analogous" to the $36 billion of equity index put options that Warren Buffett's Berkshire Hathaway Inc. has on major stock market indexes, including the S&P 500. Berkshire received $4.9 billion in derivative premiums in return for agreeing to make payments to the counterparties, starting in 2018, if the stock indexes are lower than when the contracts were signed.
Deflation Fear
With U.S. unemployment stuck near 10 percent and consumer prices rising just 1.2 percent for the 12 months ended in July, investors have been seeking financial products that would protect their holdings from deflation. Canadian insurer Fairfax Financial Holdings said in July that it bought 10-year contracts tied to consumer price indexes with a face value of $21.5 billion in this year's first half.
The price of 10-year inflation floors has risen to 146 basis points, or 1.46 percent of the face value of each contract, from an average of 78 basis points in March and as little as 42 basis points in October, according to data compiled by Bloomberg.
Pimco on average received about 87 basis points, according to the premiums reported in its filing. Premiums on 10-year inflation floors equaled about 108 basis points at June 30.
"We have seen tremendous growth since the end of last year, less so in inflation caps and more so in floors," said Allan Levin, head of structured rates for North America at Deutsche Bank Securities Inc. in New York. "It reflects an increasing fear of deflation."