The valuation of inflation linked asset swap considers only the case where the cash flows matching the bond coupon and principal repayments are linked to inflation by a scaling factor. When the indexation lag for the inflation swap is not the same as that for the zero coupon swaps there is an additional convexity correction.
The valuation of a floating LIBOR stream is standard and this report discusses only the valuation of inflation linked leg. The coupon cash flows of the inflation linked leg are given by a process.
The present value of each expected cash flow is obtained by discount it from the payment date to the value date
Zero coupon inflation swaps are usually defined with an indexation lag of two months and the expected RPI value is obtained from the forward RPI curve constructed from zero coupon (ZC) inflation swaps
When the indexation lags do not match there is an additional convexity correction that arises from a timing mismatch between the natural payment time of the forward RPI index (2 months after the index reset) and the actual payment time. For example, if m = 8 months, get expected RPI value from the forward RPI curve constructed from zero coupon (ZC) inflation swaps.
The close out reserve represents the cost of flattening out (i.e. closing out) the exposure to RPI index. The formula is used to calculate the close-out reserve, R(Close −Out), on a per bucket basis.
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