A general theory for pricing and hedging of inflation-linked derivatives is outperformed in a complete market setting without any arbitrage. The market consisting of nominal discount bonds and real discount bonds, together with the consumer price index, acts as a kind of exchange rate to determine the nominal payout of a real discount bond at the time of maturity. This article presents an overview of inflation bonds and inflation derivatives.
While bonds give a fixed returns, the returns tends to be very negligible or even negative, if the inflation effect is considered. This is true not only in developing economies like India, but also in the case of developed countries like UK and France. In order to counteract the effect of inflation, inflation-linked bonds and inflation-linked derivatives have come into being. Though they are still not available in India, they are an effective tool in counteracting the devastating effect of inflation on fixed return instruments.
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