Pricing inflation-indexed derivatives with default risk

ABSTRACTInflation-indexed derivatives with default risk are modeled using the jump-diffusion processes in the Heath–Jarrow–Morton’s (HJM) [(1992). “Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claim Valuation.” Econometrica 60: 77–105] framework. A four-factor HJM model is proposed by incorporating an exogenous intensity function into a foreign currency analogy under the three-factor HJM model proposed by Jarrow and Yildirim [(2003). “Pricing Treasury Inflation Protected Securities and Related Derivatives Using a HJM Model.” Journal of Financial and Quantitative Analysis 38: 337–358]. The proposed model improves the valuation accuracy of zero-coupon inflation-indexed swaps (IIS) through calibrating the model to swap market data. In addition, the valuation formulas of year-on-year IIS and caps with default risk are derived.