Inflation-rate Derivatives: From Market Model to Foreign Currency Analogy

Lixin Wu

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arXiv · 1302.0574

Inflation-rate Derivatives: From Market Model to Foreign Currency Analogy

Lixin Wu

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Abstract

In this paper, we establish a market model for the term structure of forward inflation rates based on the risk-neutral dynamics of nominal and real zero-coupon bonds. Under the market model, we can price inflation caplets as well as inflation swaptions with a formula similar to the Black's formula, thus justify the current market practice. We demonstrate how to further extend the market model to cope with volatility smiles. Moreover, we establish a consistency condition on the volatility of real zero-coupon bonds using arbitrage arguments, and with that re-derive the model of Jarrow and Yildirim (2003) with real forward rates based on "foreign currency analogy", and thus interconnect the two modeling paradigms.

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Lixin Wu. 2013-02-04. Inflation-rate Derivatives: From Market Model to Foreign Currency Analogy. https://arxiv.org/abs/1302.0574

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