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Estimating Inflation Option Inputs from Breakeven Inflation

Article Quant Q&A · Author: Kiann
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Summary

The document proposes a way to construct model inputs for year-on-year and zero-coupon inflation options when example quotes are unavailable. Comparing yields on Treasury Inflation-Protected Securities with yields on nominal Treasury securities of similar maturity can provide an estimate of expected inflation. A historical series of these estimates can then be used to calculate volatility for an appropriate option-pricing model.

This approach produces modeled inputs or prices, not observed inflation-option market quotes, so it may not meet a need for market-based calibration. The answer also cautions that the underlying bond instruments’ remaining lives affect the estimates: as they approach maturity, their expected-inflation volatility may decline. Restricting the source instruments to those with sufficient life, matched to the target horizon, may help address that issue. No quote dataset, pricing model specification, or empirical validation is provided.

Key ideas

  • Comparing similar-maturity nominal Treasury and inflation-protected yields can estimate expected inflation.
  • A historical expected-inflation series can provide a volatility input for an inflation option model.
  • Source instruments nearing maturity may imply lower expected-inflation volatility.
  • The resulting prices are modeled estimates rather than observed option market quotes.

Tags

OptionsFixed incomeVolatilityDerivatives pricing
Full text
# Where can I get some Inflation Option example quotes (year-on-year and zero-coupon)


# Where can I get some Inflation Option example quotes (year-on-year and zero-coupon)












I am writing an academic paper on calibration of inflation vanilla options.

I need to generate examples for the paper. Is there anywhere I can get example data for the Inflation year-on-year options, and inflation zero-coupon options?

It doesn't have to be recent, but hopefully within the past 2 years.

Kind regards

## Answer by AlRacoon (score 1)

https://quant.stackexchange.com/a/44269

This is more of a suggestion rather than an explicit source of prices.

One way one can get expected inflation from the fixed income markets. By comparing yields of TIPS to similar maturity yields on nominal Treasury Bond/Note prices, one can back out the expected inflation.

If you develop a historical series of expected inflation, you can then calculate the volatility and use this in an appropriate options pricing model.

One caveat is that the instruments where you would use to extract the expected inflation, are most likely short term and therefore will experience reduced volatility as they approach maturity. As such, the expected volatility of expected inflation will most likely decline as well. You may be able to compensate for this by only using instruments with sufficient life. For example, to extract 1Yr expected inflation by only using TIPS and nominal bonds with 1Yr to maturity.

Of course these would model prices and not market prices and therefore may not be useful to your desire to provide a calibration mechanism.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.