In SDX Interest Rates in the Settings window (see Customizing SDX Interest Rates) you can customize the behavior of the inflation instruments1.
For each currency and, if there is more than one index per currency, for each index, you can:
Customize the seasonality adjustment used to create the inflation curve. See Customizing the Seasonality Adjustment for Inflation Instruments.
Customize which reference index to use in the seasonality calculation. See Defining Which Reference Index to Use to Calculate the Seasonality.
Choose the forward index interpolation method to be used. See Selecting the Forward Index Interpolation Method for Inflation Instruments.
These settings affect the rates displayed in the Inflation Curve page (see Inflation Curve) and the relevant instrument as it is displayed in the pricing page.
You do this in the Settings window > Option/Swap tab > Inflation Swap tab.
Customizing the Seasonality Adjustment for Inflation Instruments
SDX Interest Rates builds the curve for pricing the inflation instruments2 based on previous years’ inflation rates.
However, the curve created based on prior years’ inflation rates can only be used to accurately price an instrument that has an integer number of years to maturity (such as 1 year or 3 years). Instruments that do not have an integer number of years to maturity (such as 1 year and 3 months) cannot be priced in this way. This is because inflation rates exhibit seasonality: the rate is not constant throughout the year, but, for example, may be higher at the beginning of the year than at the end.
In order to project forward inflation correctly (and to correctly build the inflation curve) for these instruments on non-integer years to maturity, the model calculates the seasonality correction from the history of the inflation index. That is, it examines the seasonality in prior years’ rates and adjusts the projected inflation index for any period during future years accordingly.
Each year of seasonality history looks at the 12 months up to and including the base reference month. For example, on 5 May 2012 the base reference month for UK RPI is March 2012. So the first year of seasonality will look at the realized monthly growth of the RPI index from March 2011 to March 2012. More years of seasonality would extend this back in time appropriately3.
SD first builds a forward inflation curve with anchor points at each anniversary of the base reference month. None of these anchor points are adjusted for seasonality, because total seasonality for each successive one-year period from the reference must be zero.
For each year of history used, SD then looks at the deviation of cumulative realized index growth versus the straight line index growth for each month in the inflation year.
So in the above example, we would have 12 adjustment factors coming from the 1st year of seasonality history, corresponding to the months of April 2011 through March 2012 (with the March 2012 adjustment being zero by definition).
If the user chooses to use more than one year of history, these adjustment factors are calculated for each year of history used, and then averaged across the years used.
The resultant adjustment factors are then applied to the appropriate month’s index projection resulting from the straight line growth between the above mentioned anchor points for any month which is not an anchor point as described above.
By default SDX Interest Rates uses five years of history in the seasonality calculation. However, you can manually set the number of years of history to use for computing the seasonality corrections (you can choose any number of years up to seven), and also change the relative weight given to each year used. For example, you may decide to put more weight on recent years, than on years further out in the past.
When estimating the seasonality corrections for inflation based on past history, there are two (conflicting) ideas to take into account:
One is that the more history that is available the better, in order to produce better statistics.
The other is the belief that the seasonality adjustment is not static, an idea which means that it is preferable to use new data for computing the estimates.
Being able to change the number of years of history used and to change the relative weight assigned to each year gives the user more control. You do this using the Settings window > Option/Swap tab > Inflation Swap tab.
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To customize seasonality adjustments:
| 1. | Access the Settings window (see Accessing the Settings Window). |
| 2. | From the View Profile Settings dropdown list select the profile you want to see the settings for. |
| 3. | Click the Option/Swap tab and then the Inflation Swap tab. |
| 4. | In the Currency dropdown list select the currency and, if there is more than one index per currency, from the Index dropdown list select the index. |
| 5. | In the Inflation Swaps-Seasonality Adjustment area select the number of years on which SDX Interest Rates should base its seasonality adjustments using the Years of History radio buttons. |
| 6. | If you select to use 2 or more years of history, you also need to define a weight for each year. |
For each year listed in the Weights area, enter a weight as a fraction of 1 (such as 0.5 or 0.25) ensuring that all the defined weights add up to 1. The higher the weight, the more significant that year’s seasonality will be in SDX Interest Rates’s calculation of seasonality adjustments.
| 7. | If you are in: |
The SD profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button and then clicking Yes) or to a public profile (by clicking the Save as Profile button, entering a profile name and user group, and then clicking Save and then OK).
A public profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button) or to the current public profile (by clicking the Save as Profile button and then Save and then OK).
Your MyProfile profile you can only save these changes to your MyProfile by clicking the Save as MyProfile button and then clicking Yes.
The changes are saved.
Defining Which Reference Index to Use to Calculate the Seasonality
The inflation indexes, which are used in the calculation of the inflation instruments4, are published with a lag, which may be set to, for example, 2 months or 3 months. So, for example, the December index may be published in the middle of February, the January index in the middle of March, etc.
For the seasonality calculation by default SD sets the reference index5 by lag definition, even if a more recently published index is available. That is, SD sets the reference index for calculating seasonality to be the index for the 1st of the month that is the lag period before the trade date. So, for example, if the trade date is 29 March 2011 and the inflation index is USCPI (whose lag is three months), then by default the reference index for calculating the index’s seasonality is for 1 December 2010.
However, if you choose to customize the seasonality adjustments (see Customizing the Seasonality Adjustment for Inflation Instruments), you can also instruct the system to calculate the seasonality using the latest reference index available, and not the reference index set by lag definition (which is the system’s default setting).
Why would you want to do this? In situations where the trade date is toward the end of the month, then it is possible that a new index has already been published (typically they are published around the middle of the month). In that case, it would make sense to use this newly published index in seasonality calculations. So, continuing with the above example, where the trade date is 29 March 2011 and the inflation index is USCPI (whose lag is three months), if you are using the latest data available then the reference index to calculate the index’s seasonality will be for 1 January 2011 instead of for 1 December 2010.
You instruct the system to use the latest reference index using the Settings window > Option/Swap tab > Inflation Swap tab > Use new index data when available checkbox.
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If you choose to activate this functionality, then the seasonality is always calculated using the newest index even if you later manually override the inflation lag in the pricing page (using the Inflation Lag field). |
This will affect the rates displayed in the Inflation Curve page (for more information on this page see See "Inflation Curve") and the relevant instrument as it is displayed in the pricing page.
To use the most recently published inflation rates for an inflation instrument:
| 1. | Click the Settings window. |
| 2. | From the View Profile Settings dropdown list select the profile you want to see the settings for. |
| 3. | Click the Option/Swap tab and then click the Inflation Swap tab. |
| 4. | In the Currency dropdown list select the currency and, if there is more than one index per currency, from the Index dropdown list select the index. |
| 5. | In the Method area check the Use new index data when available checkbox. |
| 6. | If you are in: |
The SD profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button and then clicking Yes) or to a public profile (by clicking the Save as Profile button, entering a profile name and user group, and then clicking Save and then OK).
A public profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button) or to the current public profile (by clicking the Save as Profile button and then Save and then OK).
Your MyProfile profile you can only save these changes to your MyProfile by clicking the Save as MyProfile button and then clicking Yes.
The changes are saved.
Selecting the Forward Index Interpolation Method for Inflation Instruments
When pricing an inflation instrument, the system needs to know the forward inflation index. This data (which is displayed in the system in the Inflation Curve page—see See "Inflation Curve") is only quoted for full years. Therefore, if you are pricing an inflation instrument with a non-integer number of years to maturity, such as, 17 months, the system needs to interpolate the data needed.
You can select whether you want the system to calculate its month-on-month interpolation using either a linear or exponential method.
By default, the linear method will be used. However, you can change this setting to use an exponential method using the Settings window > Option/Swap tab > Inflation Swap tab.
This setting affects the rates displayed in the Inflation Curve page (see Inflation Curve) and the relevant instrument as it is displayed in the pricing page.
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In addition, for all inflation indexes the system also needs to work out the index on a particular day. For most of these indexes, the same rate is used from one roll date up to the next roll date. However, for some, i.e., the USD index and the two French indexes, linear day-on-day interpolation is used. So for these indexes, the rate changes across the period from one roll date to the next, i.e., it is interpolated depending on how many days the index spot date falls between the preceding roll date and the succeeding roll date. For more information on this topic see Understanding the Inflation Index Conventions . |
To select the forward index interpolation method to be used:
| 1. | Access the Settings window (see Accessing the Settings Window). |
| 2. | From the View Profile Settings dropdown list select the profile you want to see the settings for. |
| 3. | Click the Option/Swap tab and then the Inflation Swap tab. |
| 4. | In the Currency dropdown list select the currency and, if there is more than one index per currency, from the Index dropdown list select the index. |
| 5. | In the Forward index interpolation method area, click the Linear or Exponential radio button. |
| 6. | If you are in: |
The SD profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button and then clicking Yes) or to a public profile (by clicking the Save as Profile button, entering a profile name and user group, and then clicking Save and then OK).
A public profile you can save these changes to your MyProfile profile (by clicking the Save as MyProfile button) or to the current public profile (by clicking the Save as Profile button and then Save and then OK).
Your MyProfile profile you can only save these changes to your MyProfile by clicking the Save as MyProfile button and then clicking Yes.
The changes are saved.