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Inflation Derivatives Inflation Derivatives Graduation Thesis Financial Engineering and Management A research on the implementation of inflation derivatives within pension funds Supervisors: Dr. D.Y. Dupont Dr. R. A. M. G. Joosten Dr. B. Roorda Drs. P. Bajema Author: C.F.A.R. Wanningen Company: Blue Sky Group Date: July 2007 Preface his thesis about inflation derivatives is the result of a six-month research which started in February and ended in July at pension fund provider Blue TSky Group. During this period I conducted a literature research on inflation linked products and developed a pricing model. Moreover I visited investment banks in London and the Euromoney Inflation Linked Products Conference 2007 in Frankfurt. The visits provided me with valuable information insights and business experience. Furthermore conversations with specialists working at Blue Sky Group and investment banks helped me to understand how inflation linked products are traded in the marketplace. By writing this preface I would gladly grasp the opportunity to thank persons who made a contribution to this thesis. From the University of Twente I would like to thank Dr. D.Y. Dupont, Dr. R.A.M.G. Joosten and Dr. B. Roorda. Dr. Dupont supervised the research and gave information insights during the first months. Dr. Roorda supervised the research throughout the whole period and initiated useful discussions on inflation. Dr. Joosten supervised the research during the last months and gave supportive suggestions on writing a thesis. From Blue Sky Group I would like to give thanks to Drs. P. Bajema, Drs. J.F. van Halewijn and A.A.M. Lute, RBA. Drs. Bajema was my mentor and traveled with me to Frankfurt and London. Furthermore Drs. Bajema actively monitored my proceeds and gave practical insights. Drs. van Halewijn, as head of the research department, provided the time to conduct the research. Mr. Lute, as chief investment officer, organized the internship at Blue Sky Group. After reading this thesis I hope that the reader has knowledge about inflation and the inflation market. Moreover I would be glad if the reader has developed an intuition for inflation derivatives modeling and pricing. Finally, this thesis is especially written in order to contribute to the readers’ opinion on the significance of inflation derivatives for pension funds. Wanningen C.F.A.R., 2007, Inflation Derivatives, Blue Sky Group. 2 TF&M_InflationDerivatives_0707.PDF Abstract owadays the global inflation market enables pension funds to offer real pensions to their schemes’ participants. Real pensions have a preference Nover their nominal counterparts because they are unaffected by unfortunate inflationary movements. Inflation linked bonds and inflation derivatives provide the required solutions that secure buying power of money over time horizons that are unrivaled in length. By covering topics such as inflation measurement and inflation modeling this thesis is especially written for those who want to know more about inflation derivatives. Inflation derivatives greatly enhance investment portfolios of pension funds. However, due to no standardized pricing models, a pension fund must have an objective pricing model for inflation derivatives. This thesis provides a detailed methodology covering all the relevant factors on pricing inflation swaptions, which gives insight in the level of complexity of an appropriate pricing model for inflation derivatives. Wanningen C.F.A.R., 2007, Inflation Derivatives, Blue Sky Group. 3 TF&M_InflationDerivatives_0707.PDF Table of Contents PREFACE........................................................................................................... 2 ABSTRACT......................................................................................................... 3 TABLE OF CONTENTS ...................................................................................... 4 LIST OF FIGURES ............................................................................................. 6 LIST OF TABLES & EQUATIONS....................................................................... 7 METHODOLOGY................................................................................................ 9 CHAPTER 1 INFLATION INDICES ................................................................. 10 1.1 Consumer price index ..........................................................................10 1.2 Seasonality ..........................................................................................11 1.3 Indexation lag.......................................................................................11 1.4 The Harmonized Indices of Consumer Prices......................................12 1.5 The Boskin Report and US CPI............................................................15 1.6 Summary..............................................................................................17 CHAPTER 2 INFLATION LINKED BONDS ..................................................... 18 2.1 Introduction ..........................................................................................18 2.2 Reasons for issuing..............................................................................19 2.3 Inflation effects.....................................................................................19 2.4 Hedging instruments ............................................................................20 2.5 Purchasing power parity.......................................................................23 2.6 Types of inflation linked bonds.............................................................24 2.7 Tax on inflation linked bonds................................................................27 2.8 Summary..............................................................................................28 CHAPTER 3 INFLATION DERIVATIVES ........................................................ 29 3.1 Motivation ............................................................................................29 3.2 Inflation swaps .....................................................................................29 3.4 Inflation payers.....................................................................................32 3.5 Inflation receivers.................................................................................35 3.6 Summary..............................................................................................36 CHAPTER 4 INFLATION MARKETS............................................................... 37 4.1 Australia...............................................................................................37 4.2 Canada ................................................................................................38 4.3 France..................................................................................................39 4.4 Sweden................................................................................................41 4.5 United Kingdom ...................................................................................43 4.6 United States .......................................................................................45 4.7 Inflation Derivatives Markets................................................................48 4.8 Future trends and market figures .........................................................49 4.9 Summary..............................................................................................51 Wanningen C.F.A.R., 2007, Inflation Derivatives, Blue Sky Group. 4 TF&M_InflationDerivatives_0707.PDF CHAPTER 5 INFLATION MODELING............................................................. 53 5.1 Introduction ..........................................................................................53 5.2 Jarrow-Yildrim model ...........................................................................54 5.3 The Mercurio model .............................................................................55 5.4 Summary..............................................................................................56 CHAPTER 6 INTERPOLATION ...................................................................... 57 CHAPTER 7 SEASONALITY & CARRY.......................................................... 59 7.1 Introduction ..........................................................................................59 7.2 Seasonality ..........................................................................................59 7.3 Carry ....................................................................................................63 7.4 Summary..............................................................................................65 CHAPTER 8 INFLATION SWAPTION PRICING THEORY.............................. 66 8.1 Definition and application.....................................................................66 8.2 Swaption pricing model of Black ..........................................................67 8.3 Convexity adjustment for YOY inflation swap rates..............................68 8.4 Summary..............................................................................................70 CHAPTER 9 PRICING MODEL EXPLANATION ............................................. 71 9.1 Model ...................................................................................................71 9.2 Seasonality trend .................................................................................76 9.3 Summary..............................................................................................78
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