Title: Joint modeling of inflation and real interest rate dynamics with application to equity-linked investment
Authors: Lasse Koskinen - University of Tampere (Finland)
Arto Luoma - University of Tampere (Finland) [presenting]
Tommi Salminen - University of Tampere (Finland)
Abstract: A realistic model is introduced for the joint dynamics of real interest rate and inflation so that it could be used for various prediction purposes, for example to analyze the role of inflation in the pricing and hedging of financial derivatives. In a combined auto-regressive process, normal or more stable inflation periods are explained by a standard AR-process, while unanticipated peaks are captured by an additional process following Student's $t$-distribution. Next, the effect of inflation on the pricing of an equity index linked insurance product is studied. The models are estimated using Bayesian methods with US data.