Modeling Inflation: Pricing Inflation-Linked Products
Inflation eats your money. Slowly, usually, but sometimes fast. If you hold a regular bond, inflation erodes the value of every coupon and the principal repayment. Index-linked bonds solve this by tying payments to an inflation index like the Consumer Price Index (CPI) in the US or the Retail Price Index (RPI) in the UK. Chapter 71 of Wilmott’s book looks at how to model inflation and price these products. The answer turns out to be messier than you might hope.