Pricing inflation products with stochastic volatility and stochastic interest rates

Stefan N. Singor, Lech Grzelak, David van Bragt () and Cornelis Oosterlee

Insurance: Mathematics and Economics, 2013, vol. 52, issue 2, 286-299

Abstract: We consider a Heston type inflation model in combination with a Hull–White model for nominal and real interest rates, in which all the correlations can be non-zero. Due to the presence of the Heston dynamics our derived inflation model is able to capture the implied volatility skew/smile, which is present in the inflation option market data. We derive an efficient approximate semi-closed pricing formula for two types of inflation dependent options: index and year-on-year inflation options. The derived pricing formulas allow for an efficient calibration of the inflation model. We also illustrate our approach using a real-life pension fund example, where the Heston Hull–White model is used to determine the value of conditional future indexations.

Keywords: Heston Hull–White model; Inflation; Affine diffusion processes; Monte Carlo simulation; Indexation provision; Pension fund (search for similar items in EconPapers)
JEL-codes: C02 C13 C58 C63 G12 G13 G22 G23 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:52:y:2013:i:2:p:286-299

DOI: 10.1016/j.insmatheco.2013.01.003

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