Pricing and Hedging of Inflation-Indexed Bonds in an Affine Framework

21 Pages Posted: 19 Oct 2013

See all articles by Zehra Eksi

Zehra Eksi

Vienna University of Economics and Business, Institute for Statistics and Mathematics

Damir Filipović

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Date Written: October 1, 2013

Abstract

This study deals with the pricing and hedging of inflation-indexed bonds. Under foreign exchange analogy we model the nominal short rate, real short rate and logarithm of the price index with an affine Gaussian process. Using the underlying affine property, we compute the nominal and inflation-indexed bond prices explicitly. We derive no-arbitrage drift conditions for the factor process. Then, we perform a novel hedging analysis where our objective is to replicate an indexed bond of a given maturity by trading a portfolio of nominal bonds. This analysis leads to a hedging criterion based on a set of restrictions on the eigenvalues and the eigen vectors of mean reversion speed matrix of the factor process. We fit the model to the U.S. bond data and perform an in-sample hedging analysis. Having relatively small in-sample hedging errors, we validate the theoretical hedging result for the considered dataset.

Keywords: affine Gaussian processes, inflation-indexed bonds, no-arbitrage, pricing, hedging, market completeness

Suggested Citation

Eksi, Zehra and Filipovic, Damir, Pricing and Hedging of Inflation-Indexed Bonds in an Affine Framework (October 1, 2013). Swiss Finance Institute Research Paper No. 13-54. Available at SSRN: https://ssrn.com/abstract=2342209 or http://dx.doi.org/10.2139/ssrn.2342209

Zehra Eksi (Contact Author)

Vienna University of Economics and Business, Institute for Statistics and Mathematics ( email )

Welthandelsplatz 1
Building D4, 4th floor
Vienna, 1020
Austria

Damir Filipovic

Ecole Polytechnique Fédérale de Lausanne ( email )

Odyssea
Station 5
Lausanne, 1015
Switzerland

HOME PAGE: http://people.epfl.ch/damir.filipovic

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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