Quadratic Gaussian inflation

Quadratic Gaussian models are particularly amenable to analytic solutions, and so have become popular for rates modelling. Here, Manlio Trovato, Diana Ribeiro and Hringur Gretarsson extend the approach to inflation, and show that realistic smile and convexity corrections can be obtained

The liquidity and transparency of the inflation options market has increased considerably in recent years, with all major brokers now providing screens with prices of year-on-year and zero-coupon caps and floors at various strikes. These prices show that the inflation market is characterised by a pronounced smile and skew in implied option volatilities, with implied distributions of year-on-year forwards having pronounced fat tails. It is therefore important that inflation derivatives pricing