Inflation-indexed securities - Inflation with a smile
In the current inflation-indexed markets, most traded options have zero or even negative strikes. This highlights the need for a smile-consistent valuation of caps and floors on inflation rates. To this end, Fabio Mercurio and Nicola Moreni propose a stochastic volatility model for forward consumer price indexes, with volatility dynamics following a square-root process as in Heston (1993). Using a Fourier transform approach, they derive closed-form formulas for inflation-indexed caplets and floorlets
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