Interpreting implied risk-neutral densities: the role of risk premia
David Vestin and
Peter Hördahl
No 274, Working Paper Series from European Central Bank
Abstract:
This paper examines differences between risk-neutral and objective probability densities of future interest rates. The identification and quantification of these differences are important when risk-neutral densities (RNDs), such as option-implied RNDs, are used as indicators of actual beliefs of investors. We employ a multi-factor essentially affine modeling framework applied to German time-series and cross-section term structure data in order to identify both the risk-neutral and the objective term structure dynamics. We find important differences between risk-neutral and objective distributions due to risk premia in bond prices. Moreover, the estimated premia vary over time in a quantitatively significant way, which implies that the differences between the objective and the risk-neutral distributions also vary over time. We conclude that one should be cautious in interpreting RNDs as representing the true expectations of market participants. The method used in this paper provides an alternative approach to identifying probabilities of future interest rates. JEL Classification: G12, E43
Keywords: essentially affine term structure model; Risk-neutral densities; risk premia (search for similar items in EconPapers)
Date: 2003-09
Note: 343743
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)
Downloads: (external link)
https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp274.pdf (application/pdf)
Related works:
Journal Article: Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia (2005) 
Journal Article: Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia (2005) 
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
HTML/Text
Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:2003274
Access Statistics for this paper
More papers in Working Paper Series from European Central Bank 60640 Frankfurt am Main, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Official Publications ().