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The inflation index

Prometeia financial modelling insights - White paper


Financial Modelling Insights: the inflation index

Here we elucidate the process required to produce financial scenarios of the ‘inflation index’ variable. Such a simulation has been performed within the risk neutral framework.

Inflation plays a key role in financial markets, and indeed this variable is one of the targets of the monetary policies of central banks. Moreover, due to the impact of inflation on investors’ behaviour, in recent years, an increasing number of instruments have been quoted on financial markets. Such instruments allow to mitigate risks and to seize opportunities linked to inflation.

Inflation has a number of unique features: its value is set by measures of real economy whereas financial markets indicate expectations on its future values. These and other features generate some constraints on inflation models, thus particular attention is required when implementing a new one. For instance, a coherence constraint between inflation levels and interest rate variables is crucial for many inflation models.

In recent years, some economies have witnessed deflation trends: due its peculiarity, this dynamic has sparked new interest in modelling inflation. 

In more practical terms, we will argue the steps needed to simulate inflation using the Jarrow-Yildirim model.