ABSTRACT
This chapter shows that the zero-coupon inflation-indexed swaps (ZCIIS)- and year-on-year inflation indexed swaps (YYIIS)-based market models are identical and the use of “convexity adjustment” is wrong and unnecessary. It introduces major inflation derivatives and highlight real zero-coupon bonds. The chapter discusses the notion of forward inflation rates, rebuild the extended market model, and develop a Heath-Jarrow-Morton type model in terms of continuous compounding forward nominal and inflation rates. It devotes to pricing major inflation-indexed derivatives under the market model, floors and swaptions. The chapter discusses the comprehensive calibration of the market model, and demonstrate some calibration results with market data. In the marketplace, YYIIS are treated as another set of securities parallel to ZCIIS, and the “inflation forward rates” implied by YYIIS and ZCIIS can be different. The price of a YYIIS is the difference in value of the fixed leg and floating leg.
