ABSTRACT
A major application of the cross-economy BGM model of Chapter-14 is to inflation (see Jarrow et al [68] for the original paper articulating cross-economy HJM to inflation), where the consumer price index (CPI) takes the place of the foreign currency exchange rate. Thus in this chapter the variable S (t) denotes the CPI, which is the price in inflatable dollars in our nominal-world of one inflation proof zlotty in real-world, that is Z1 = $S (t). As in the crosseconomy model, superfix f to nominal-world variables to denote real-world variables. Calibration involves stripping nominal and real curves, and identifying for-
ward CPI volatility functions (with correlations) along with a satisfactory forward inflation curve. Once that is done, the pricing and hedging of products is usually straightforward.
