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Rational models for inflation-linked derivatives

Dam, HT; Macrina, A; Skovmand, D; Sloth, D; (2020) Rational models for inflation-linked derivatives. SIAM Journal on Financial Mathematics , 11 (4) pp. 974-1006. 10.1137/18M1235764. Green open access

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We construct models for the pricing and risk management of inflation-linked derivatives. The models are rational in the sense that linear payoffs written on the consumer price index have prices that are rational functions of the state variables. The nominal pricing kernel is constructed in a multiplicative manner that allows for closed-form pricing of vanilla inflation products suchlike zero-coupon swaps, year-on-year swaps, caps and floors, and the exotic limited-price-index swap. We study the conditions necessary for the multiplicative nominal pricing kernel to give rise to short rate models for the nominal interest rate process. The proposed class of pricing kernel models retains the attractive features of a nominal multicurve interest rate model, such as closed-form pricing of nominal swaptions, and it isolates the so-called inflation convexity-adjustment term arising from the covariance between the underlying stochastic drivers. We conclude with examples of how the model can be calibrated to EUR data. Read More: https://epubs.siam.org/doi/10.1137/18M1235764

Type: Article
Title: Rational models for inflation-linked derivatives
Open access status: An open access version is available from UCL Discovery
DOI: 10.1137/18M1235764
Publisher version: https://doi.org/10.1137/18M1235764
Language: English
Additional information: This version is the version of record. For information on re-use, please refer to the publisher's terms and conditions.
UCL classification: UCL
UCL > Provost and Vice Provost Offices
UCL > Provost and Vice Provost Offices > UCL BEAMS
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Maths and Physical Sciences
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Maths and Physical Sciences > Dept of Mathematics
URI: https://discovery.ucl.ac.uk/id/eprint/10105230
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