Inflation Derivatives Under Inflation Target Regimes

Abstract

Inflation targeting—the central bank practice of attempting to keep inflation levels within fixed bounds around a quantitative target—has been adopted by more than 20 economies. Such practice has an important impact on the stochastic nature of inflation and, consequently, on the pricing of inflation derivatives. We develop a flexible model of inflation targeting in which the central bank's intervention to steer inflation toward the target depends on past deviations and the policymaker's ability and will to enforce the target. We use our model to price inflation derivatives and demonstrate the impact of inflation targeting on derivative pricing.