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On the White Board - January 2008
Jan 15, 2008
Inflation Risk
Our last Research Monthly focused on our treatment of what effectively is an altogether new type of risk in our analytics: inflation risk. The analytics we discussed then are now available in RiskServer, version 4.5. In large part, these analytics are the sort of thing that once you get them right, it all looks so simple and obvious that you lose the perspective of how much work it was to get there.
As we argued in the Monthly, the notion of break-even inflation (BEI) as a risk factor for all types of inflation exposures – true liabilities, bonds and derivatives – is natural, and yet this is not the language that the bond market, at least, gravitated to on its own. This meant undoing (and unlearning) to some extent the notion of real yields for bonds to arrive at inflation risk expressed in terms of the BEI for all markets.
Getting the details right for BEI data and for pricing models that incorporate this data was challenging, to say the least, but it leaves us in an exciting position. We are not there yet, but we now have the pieces in place to treat many of the newer inflation-linked derivatives and structured products. And the framework we have built, where we strip any specific market nuances to create clean BEI curves, means that our analytics lie in wait for curves we produce for the lesser developed, or more exotic, inflation markets.
Sourcing data is a challenge, true, but we think we have isolated the problem to just that. In short, there is a lot of hard work behind us, and a lot of excitement ahead. Stay tuned!