Convexity adjustments in inflation-linked derivatives
Dorje Brody, John Crosby and Hongyun Li value several types of inflation-linked derivatives using a multi-factor version of the Hughston (1998) and Jarrow & Yildirim (2003) model. Expressions for the prices of zero-coupon inflation swaps with delayed payment and period-on-period inflation swaps with delayed payments are obtained in closed form by explicitly calculating the relevant convexity adjustments. These results are then applied to value limited price indexation swaps using Ryten's (2007) common-factor representation methodology
The market for inflation-linked derivatives has grown rapidly in recent years. Inflation is now regarded as an independent asset class. Actively traded inflation derivatives include standard zero-coupon inflation swaps, as well as more complicated products such as period-on-period inflation swaps (Mercurio, 2005), inflation caps (Mercurio, 2005), inflation swaptions (Kerkhof, 2005) and futures contracts written on inflation (Crosby, 2007).Dorje Brody is a reader in mathematics at Imperial College London, John Crosby is a visiting professor of quantitative finance in the department of economics at the University of Glasgow, and Hongyun Li is a PhD student at Imperial College London. They would like to thank Mark Davis for discussions and Terry Morgan for providing the market data used in the examples. Feedback from two anonymous referees is gratefully appreciated.
Convexity adjustments in inflation-linked derivatives (PDF, 396KB)
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