The economics of options-implied inflation probability density functions
Yuriy Kitsul and
Jonathan H. Wright
Journal of Financial Economics, 2013, vol. 110, issue 3, 696-711
Recently a market in options based on consumer price index inflation (inflation caps and floors) has emerged in the US. This paper uses quotes on these derivatives to construct probability densities for inflation. We study how these probability density functions respond to news announcements and find that the implied odds of deflation are sensitive to certain macroeconomic news releases. We also estimate empirical pricing kernels using these option prices along with time series models fitted to inflation. The options-implied densities assign considerably more mass to extreme inflation outcomes (either deflation or high inflation) than do their time series counterparts. This yields a U-shaped empirical pricing kernel, with investors having high marginal utility in states of the world characterized by either deflation or high inflation.
Keywords: Inflation; Floors and caps; Derivatives; Forward martingale measure; Physical measure (search for similar items in EconPapers)
JEL-codes: C22 E31 E44 G12 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:110:y:2013:i:3:p:696-711
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