HOWTOPRICEYEARONYEARINFLATION

SWAPSANDOPTIONS

Intheinflationmarketwewitnessaninterestingpeculiarity:whilstthemosttradedtypeofinflation
swapis(asnow)theZeroCoupontype,inflationcapsandfloorsareinsteadbasedonaYearon
Yearcoupontype.Thisimpliesthattheunderlyingofcaps/floors(thefloatinglegofayearon
yearswap)islargelynotobservableinthemarketplaceandmustinsteadbebuiltsynthetically.

SETTINGS:

Our{SWIL<go>}functionallowstogenerateYearonYearquotesbycustomizingthefollowing
inputs:
A)InflationZeroCouponcurvescanbeeitherobtainedfromacontributor(namelyamarketmaker,
aninterdealerbrokeroraBloombergcompositeprice)orbeuserinputted;

B)InflationVolatility.Inflationvolatilityisfullycustomizable,themarketcurrentlyquotescapsand
floorspremiums(basispointsupfront)whichweconvertintovolatilitysurfaces.
Volatilityhasatwofoldusage;itisaninputtocalculatetheconvexityadjustmentsnecessaryto
convertzerocouponquotesintoyearonyearquotes(thereforeprovidingtheunderlyingforboth
yearonyearswapsandcaps/floors)andalsotoappraisethetimevalueofinflationcaps/floors.

Inflationvolatilitycanbeexpressedeitherasshiftedlognormalornormal,alsoallowingfor
negativestrikeprices.
C)Oncedefinedthesettingsforzerocouponcurvesandvolatility,theDetailspageofSWILallows
tochoosethesettingsforthegenerationoftheconvexityadjustmentvector.

Userscandecidewhetherornot:
toapplytheconvexityadjustmentforvaluationofallswapsandoptionsoninflation;
toextracttheadjustmentfrommarketpricesorinputit;


toapplyaPutCallParitymodeloraJYModel.
PutCallParity:Thismethodismodelindependentandbasedontheassumptionthatthe
contributorselectedintheVolatilitytabofthesettingfunctionSWILprovidescapandfloorquotes
withatleastonecommonstrike.TheYoYconvexitycorrectionisthencalculatedbyapplyingthe
putcallparitytothequotedprices:thedifferencebetweenacap,withgivenstrikeKandmaturityT,
andafloor,withthesamestrikeandmaturity,isaYoYswapwithmaturityTandwithfixedrateK.
JYModel:Thismethodcalibratesthefunctionalformofconvexitycorrectionderivedunderthe
modelofJarrowandYildirim(PricingTreasuryInflationProtectedSecuritiesandRelatedDerivatives
usinganHJMModel.JournalofFinancialandQuantitativeAnalysis38(2),409430.2003).TheJY
modelisathreefactormodelwherenominalandrealinstantaneousshortratesareassumedto
followHJMGaussianprocessesandtheCPIevolvesaccordingtoalognormalprocess.TheJYmodel
hastheadvantageofimplyingclosedformformulasfortheconvexitycorrectionandforcapsand
floors.

D)Oncealltheabovesettingshavebeenchosen,wecreatevectorsofbidandaskratesforyearon
yearswaps

PRICING:

AfterdeterminingwithaccuracythevectorofYearonYearswaprates,wecanproceedtoprice
derivativesbaseduponit.
Our{SWPM<go>}functionallowstostructure,price,saveandreevaluatethefollowinginflation
instruments:
ZCInflationSwaps(pleaseconsulttheZChelpdocumentformoreinformation)versusfixedor
float;
YoYInflationSwapsversusfixedorfloat;
YoYCaps/Floors.

YoYSWAPS:
ThetraditionalYearonYearstructurewillmergeaYoYinflationlegwithaFixedleg;theswap
couponwillbesolvedforthatlevelthatmakestheswapparatinception.

Someusefulexplanation:
ThelagperiodreferstothedifferencebetweentheCPIdateandtheinflationleg'seffectiveor
maturitydate.SincemostCPIsonlyprovidemonthlydata,interpolationmethodisthemethodby
whichtodeterminethesettlementdatepatternifthedealstartsorendsinthemiddleofone
month.

SWPMsupportsthefollowinginterpolationmethods:


MIRMonthlyInterpolation.Thesettlementisalwayssetonthe1stofthestartandendmonth,
whichmeansCPIvalueswouldbethedirectmonthlyvaluefortheseparticularmonths.Forexample,
ifthelagperiodisthreemonths,thecouponrateforoneperiodis:(MonthlyCPIon3monthbefore
nextPaymentdate/MonthlyCPIon3monthbeforepreviouspaymentdate1)x100%.
DIRDailyInterpolation.Thesettlementdatesaretheoriginaldatesthatcanbeinthemiddleofa
month.CPIvaluesarethedailyweightedaverageofthatmonthandnextmonth'sCPIvalues.The
calculationthatappearsinthedefinitionofMIRabovedisplaysfurtherinformation.

TheleveragerepresentsthemagnitudeofthereflectiononCPImovementsontheinflationleg
coupons(avalueof1.000meansthata2%increaseinCPIinayearwillgeneratea2%coupononthe
inflationleg;avalueof2.000wouldmeanthata2%increaseinCPIinayearwillgeneratea3%
couponontheinflationleg.Etc..)
ThespreadisafacultativefixedcoupontoaddtotheCPIappreciationwithintheinflationleg.
Whilstcashflowsarediscountedatlibor,theyaregeneratedusingalltheinflationinputssetinSWIL,
namelyZCcurves,Inflationvolatilitysurface,convexityadjustmentmethod(putcallparityorJY)and
seasonality.TheCurvespageinSWPMsummarizessomeofthisinformation:

Additionalinformationisdisplayed(andcanbefurthercustomized)intheLegDetailpage,where
thedealcanalsobecustomizedwithanamortizingschedule.

YoYCAPS/FLOORS:
Forinflationcaps/floorsmostoftheexplanationofsettingsandthefieldsavailableforinflation
swaps(leverage,lag,interpolation,convexityadjustment,etc)hold.
Herewewillprovidemoreinformationonthespecificfeaturesoftheseoptions.
Capsdefaulttoa5yearcapletsstrip(obviouslytheexpiryiscustomizable)andthecapsstrikeisset
attheATMlevelforthespecificcurrencyandexpiry.
TheimpliedvolatilityusedtopricetheoptionisderivedfromtheBloomberginflationvolatility
surface(fromtheSWILsettingsfunction)andisalwaysexpressedinSWPMasshiftedlognormal
volatility.
Theyieldvaluerepresentsthepremiumtranslatedintorunningyield,basedonthedealfrequency
anddaycountbases.

SHORTCUTS:
Thepricingfunctionalitycanbeaccessedwithshortcuts;alist:

{SWPMILFX<go>}Zerocouponinflationswapversusfixed
{SWPMILFL<go>}Zerocouponinflationswapversusfloat
{SWPMILFXYOY<go>}YearonYearinflationswapversusfixed
{SWPMILFLYOY<go>}YearonYearinflationswapversusfloat
{SWPMILCAP<go>}YearonYearinflationcaps
{SWPMILFLR<go>}YearonYearinflationfloors