Valuation of Inflation Swap Volatility Under a Market Model and Pricing of Real Yield Options
Posted: 18 Oct 2004
Date Written: October 15, 2004
The inflation market, despite its exploding growth remains not very liquid except for vanilla derivatives. And unlike interest rates, it does not yet offer liquid and reliable swaption prices. Key objective of this paper is to compute inflation swaption volatility from liquid year on year volatility. Following a similar method as for the derivation of swaption volatility from interest cap in a market model, we derive a closed form solution for the inflation swaption volatility. We examine various more simple methods to compare our relative value computation. Using this estimate of the inflation volatility, we compute not only inflation swaption but also options on real yield and inflation spreads.
Keywords: Inflation swaption, year-on-year volatility, implied volatility, correlation, real yield option
Suggested Citation: Suggested Citation