Workgroup Financial Mathematics

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Implementation and Calibration of an Inflation Market Model

Title: Implementation and Calibration of an Inflation Market Model

Responsible: Lars Maurath

Supervisor: Christian Fries

Dates: SS 2015


The goal of this thesis is to review literature on the modeling of inflation derivatives and to implement a model that can be calibrated to market data and which is able to price common inflation derivatives. We choose Mercurio’s second market model, since it has the advantages of an easy calibration procedure and it allows us to extend an already existing implementation of a LIBOR market model. In line with Mercurio’s paper we derive (approximately) analytic formulas for year-on-year inflation swaps and inflation-indexed caplets allowing for a fast calibration of the model. Along the calibration process we also show how to strip prices of inflation- indexed caplets from quoted cap prices. We further discuss issues inherent in inflation modeling, namely the possible segmentation between zero-coupon and year-on-year swap markets and between zero-coupon bond and zero-coupon swap markets. The thesis closes with a discussion on possible extensions of inflation market models and other modeling approaches.