INFLATION RISK PREMIUM DERIVED FROM FOREIGN EXCHANGE OPTIONS

Eddy Azoulay (), Menachem Brenner () and Yoram Landskroner ()
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Eddy Azoulay: Bank of Israel

No 2007.01, Bank of Israel Working Papers from Bank of Israel

Abstract: Inflation expectations are a key economic variable for investors in capital markets and for economic policy decision makers. One of the widely used sources for deriving inflation expectations is market price of bonds. The yield differential between nominal bonds and inflation-indexed (linked) bonds is taken to be an estimate of expected inflation. The problem is, however, that in a risk-averse world the yield differential includes an inflation risk premium and thus the yield differential provides an upward bias of inflation expectations. The novelty of our paper is that we estimate this risk premium using the volatility implied in options prices. In the absence of a market in options on inflation we use prices of foreign currency options to estimate this risk premium. The theoretical foundation of our methodology is purchasing power parity theory. The Israeli financial market has both, an inflation-linked and unlinked bond market and an active FX options market. Using data from both markets we find a statistically and economically significant inflation risk premium.

Keywords: Inflation expectations; Inflation risk premium; Inflation indexed bonds; foreign exchange options; Purchasing Power Parity; Error Correction Model (search for similar items in EconPapers)
JEL-codes: E31 E44 E52 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2007-03
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