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The economics of options-implied inflation probability density functions

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  • Kitsul, Yuriy
  • Wright, Jonathan H.
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    Abstract

    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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 110 (2013)
    Issue (Month): 3 ()
    Pages: 696-711

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    Handle: RePEc:eee:jfinec:v:110:y:2013:i:3:p:696-711

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Inflation; Floors and caps; Derivatives; Forward martingale measure; Physical measure;

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    References

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    2. James H. Stock & Mark W. Watson, 2007. "Why Has U.S. Inflation Become Harder to Forecast?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 3-33, 02.
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