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Title: Inflation - Linked Option Pricing: A Market Model Approach wtih Stochastic Volatility
Keywords: inflation option, stochastic volatility, convexity adjustment, calibration
Issue Date: 16-Aug-2010
Citation: LIANG LIFEI (2010-08-16). Inflation - Linked Option Pricing: A Market Model Approach wtih Stochastic Volatility. ScholarBank@NUS Repository.
Abstract: Inflation-linked derivatives? modeling is a relatively new branch in financial modeling. Originally it was adapted from interest rate models; but attention is currently turning to market model. In this thesis, we extend stochastic volatility market model to two-factor setting. The analysis in this thesis shows that two-factor model offers more profound structure and greater flexibility of fitting volatility surface while retaining the tractability of one-factor model. We then apply the two-factor model to two related issues. Hedging analysis is conducted from a new perspective where zero-coupon (ZC) options are used to hedge year-on-year (YoY) options. This can be of great practical interest as it leverages on a complicated trading book and saves on transaction cost. Convexity adjustment is also approximated under the model. Furthermore, we have illustrated in detail how it can be captured via concrete trading activities. The new two-factor model regime and broader scope which aims to calibrate both ZC and YoY options with one model, call for new calibration procedures. In this thesis, two approaches have been proposed. Firstly, we devise an interpolation scheme that yields a market consistent interpolation. A calibration against these interpolated prices can reveal mispricing and, thus, arbitrage opportunities between the two options markets. However, a more thorough analysis is necessary to determine if a misprice can really constitute an arbitrage opportunity. Secondly, to mitigate the arbitrary nature of interpolation, we propose a non-interpolation-based calibration scheme. In this approach, only market-quoted prices are inputs of calibration. ZC and YoY option prices are weighted differently to reflect their respective market liquidity and bid-offer spreads. With this thesis, we fulfilled the aim to build a comprehensive framework under which an inflation-linked option pricing model can be calibrated and applied.
Appears in Collections:Master's Theses (Open)

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