Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 49. Valuing Inflation Derivatives

JEROEN KERKHOF, PhD

Vice President, Morgan Stanley

Abstract: Many financial institutions trade inflation derivatives these days in order to hedge their inflation risk. In risk-managing these derivatives, they need a valuation and risk framework. The key component for the valuation of inflation derivatives is the forward index curve. With this curve and a nominal discount curve, all linear inflation derivatives can be valued. In risk-managing an inflation book, the risk manager faces some risks specific for inflation derivatives such as inflation and seasonality risk. Besides linear derivatives, a number of nonlinear inflation derivatives exist in the market whose valuation is volatility sensitive.

Keywords: inflation derivatives, zero-coupon inflation swaps, year-on-year inflation swap, real swaptions, curve building, Jarrow-Yildirim model

The commoditization and transfer of inflation risk is one of the major goals of the inflation derivatives market. In order for financial institutions to operate in such a market, a valuation framework is necessary. This chapter provides the basis for such a framework. A primary need for good risk management of an inflation portfolio and the valuation of more advanced inflation derivatives is the ability to mark to market the basic linear inflation derivatives. Just as a discount curve is necessary to mark to market interest rate products, an inflation curve is needed to mark inflation products. A detailed ...