Pricing of interest rate and inflation linked swap products in Europe - using a ARIMA model of EU finflation

Abstract

The European market has seen a rapid growth in the scale of trading of interest and inflation linked products. In fact, statistics from Deutsche Bank reveal that there was a 30% growth in the scale of trading in inflation linked swaps which are not only used as a hedging mechanism but also are traded as purely speculative products, for traders taking a view on inflation. These swaps can also allow clients to generate a synthetic inflation linked debt profile. In this report, we have come up with a unique auto-regressive ARIMA pricing model which values the inflation linked products in the market. While there are many models for forecasting inflation, the authors believe that there is no concrete model which incorporates both the market view on inflation and the local market conditions which are reflected in the yield curve during a particular period. The model that we develop is then tested on the inflation-linked products taken from the promotional literature of Deutsche Bank in order to check for its accuracy and robustness. The three products that we have chosen are linked with the inflation rate in the economy and are tied to the HICP index in Europe. The first phase of the project involves, evolving a time series based ARIMA autoregressive model to forecast the HICP index, i.e. the inflation rate in the European economy over the next 10 years. We then move on to model the interest rates in the economy and plot the yield curve by using the Nelson- Siegel’s method. Based on the above model, we price the three products that were structured by Deutsche Bank for their clients. . This model can also be a useful tool for clients who want to value the swaps before they enter into buying such inflation based products through the course of the duration of the product. Finally, the authors believe that the same model can be extended to price other interest rate products like caps, collars and swaptions, once the structure of the same is decided.