Pricing Inflation Indexed Derivatives: A Reinterpretation of the Jarrow-Yildirim model

Posted: 30 Jul 2008 Last revised: 22 Jun 2016

See all articles by Paul Canty

Paul Canty

Deutsche Bank AG (London)

Alessandro Paolo Luigi Cipollini

Deutsche Bank, Fixed Income Research; Università Degli Studi del Sacro Cuore di Milano - Laboratory of Statistics; University of Milan-Bicocca - Department of Mathematics and Applications

Date Written: July 29, 2008

Abstract

The Jarrow and Yildirim model for pricing inflation indexed derivatives is still the main reference technique adopted in the inflation market. Despite its popularity it has several shortcomings, the most immediate of which is the difficulty of calibration to market prices of options. The model relies heavily on the nominal and real economies, whilst the market trades options on the inflation rate or index. We offer a reinterpretation of the Jarrow and Yildirim approach based upon the notion of breakeven inflation. The main advantage is that the pricing of the most popular inflation derivatives (i.e. zero coupon and year-on-year swaps and zero coupon and year-on-year caps and floors) amounts to calibrating just three parameters: breakeven volatility, the volatility of the CPI price index and the correlation between them. The resulting Black-Scholes implied volatilities are very straight-forward to implement and the geometric interpretation of the model makes it intuitive to calibrate.

Keywords: Inflation indexed derivatives, Jarrow and Yildirim model, Zero Coupon and Year-on-Year volatility

JEL Classification: G15, G13, E31, C21

Suggested Citation

Canty, Paul and Cipollini, Alessandro Paolo Luigi, Pricing Inflation Indexed Derivatives: A Reinterpretation of the Jarrow-Yildirim model (July 29, 2008). Available at SSRN: https://ssrn.com/abstract=1186528

Paul Canty

Deutsche Bank AG (London) ( email )

Winchester House
1 Great Winchester Street
London, EC2N 2DB
United Kingdom

Alessandro Paolo Luigi Cipollini (Contact Author)

Deutsche Bank, Fixed Income Research ( email )

Winchester House
Great Winchester Street, 1
London EC2N 2DB
United Kingdom

Università Degli Studi del Sacro Cuore di Milano - Laboratory of Statistics ( email )

Via Necchi 9
Milano, MI 20121
Italy

HOME PAGE: http://www.unicatt.it

University of Milan-Bicocca - Department of Mathematics and Applications ( email )

Piazza dell'Ateneo Nuovo, 1
Milano, MI 20126
Italy
+390264485728 (Phone)

HOME PAGE: http://www.matapp.unimib.it

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