In finance, inflation derivative (or inflationindexed derivatives) refers to an overthecounter and exchangetraded derivative that is used to transfer inflation risk from one counterparty to another. See Exotic derivatives.
YouTube Encyclopedic

1/3Views:2 5481 2221 028

Index Linked Bonds and Inflation Derivatives  Dr. David Cox

Derivative Strategies  Zero Coupon Swaps Pricing (ZCSP)

The Manipulation of Interest Rates and Inflation
Transcription
Contents
Derivative
Typically, real rate swaps also come under this bracket, such as asset swaps of inflationindexed bonds (governmentissued inflationindexed bonds, such as the Treasury Inflation Protected Securities, UK inflationlinked giltedged securities (ILGs), French OATeis, Italian BTPeis, German Bundeis and Japanese JGBis are prominent examples). Inflation swaps are the linear form of these derivatives. They can take a similar form to fixed versus floating interest rate swaps (which are the derivative form for fixed rate bonds), but use a real rate coupon versus floating, but also pay a redemption pickup at maturity (i.e., the derivative form of inflationindexed bonds).
Inflation swaps are typically priced on a zerocoupon basis (ZC) (like ZCIIS for example), with payment exchanged at the end of the term. One party pays the compounded fixed rate and the other the actual inflation rate for the term. Inflation swaps can also be paid on a yearonyear basis (YOY) (like YYIIS for example) where the yearonyear rate of change of the price index is paid, typically yearly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate used is still the yearonyear rate.
Options on inflation including interest rate caps, interest rate floors and straddles can also be traded. These are typically priced against YOY swaps, whilst the swaption is priced on the ZC curve.
Asset swaps also exist where the coupon payment of the linker (inflation bond) as well as the redemption pickup at maturity is exchanged for interest rate payments expressed as a premium or discount to LIBOR for the relevant bond coupon period, all dates are coterminus. The redemption pickup is the above par redemption value in the case of par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The proceeds notional equals the dirty nominal price of the bond at the time of purchase and is used as the fixed notional on the LIBOR leg.
Real rate swaps are the nominal interest swap rate less the corresponding inflation swap. As for modelling, the trend has been either to provide :
 a model describing at the same time, nominal rates, real rates and inflation and representing the inflation as the exchange rate between nominal and real rates. The first type of model along these lines has been the one of Jarrow and Yildirim.
 a market model that represents the inflation like a real asset and uses similar ideas as the one of BGM to represent the inflation returns. The first type of model along these lines has been the one of Blegrade, Benhamou, Koehler^{[1]} that is commercially available in Pricing Partners modelling suite.^{[2]} Another more advanced version has been the one of Fabio Mercurio and Nicola Moreni^{[3]}
References
 ^ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=576081, A Market Model for Inflation by Nabyl Belgrade, Eric Benhamou, Etienne Koehler, January 2004
 ^ http://www.derivsource.com/articles/pricingpartnersextendssignificantlyitsinflationmodulemarketstandard%E2%80%9Cbbk%E2%80%9Dmodel, Pricing Partners Extends Significantly its Inflation Module with the Market Standard BBK Model, June 2009
 ^ http://www.fabiomercurio.it/stochinf.pdf, Pricing Inflation Indexed options with stochastic volatility, Fabio Mercurio, Nicola Moreni, August 2005
Further reading
 Brice Benaben; "InflationLinked Products: A Guide for Asset and Liability Managers" Risk Books, 2005. ISBN 1904339603.
 Deacon, Mark, Andrew Derry, and Dariush Mirfendereski; InflationIndexed Securities: Bonds, Swaps, and Other Derivatives (2nd edition, 2004) Wiley Finance. ISBN 0470868120.
 Brigo, Damiano and Fabio Mercurio; "Interest Rate Models  Theory and Practice, with Smile, Inflation, and Credit" (2nd edition, 2006) Springer Finance. ISBN 3540221492.
 Canty, Paul and Markus Heider; "Inflation Markets: A Comprehensive and Cohesive Guide" (2012) Risk Books. ISBN 9781906348755.
External links
 ISDA Inflation Derivatives Definitions
 Hughston; "Inflation Derivatives"
 Jarrow & Yildirim; "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model" Journal of Financial and Quantitative Analysis, Vol. 38, No. 2, June 2003
 Huang & Cairns; "Valuation and Hedging of LPI Liabilities"
 Hoare Capital Markets LLP
 "Savvysoft prices inflation derivatives