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Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia

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  • Peter Hördahl
  • David Vestin

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

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File URL: http://hdl.handle.net/10.1007/s10679-005-2989-7
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Bibliographic Info

Article provided by Springer in its journal Review of Finance.

Volume (Year): 9 (2005)
Issue (Month): 1 (03)
Pages: 97-137

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Handle: RePEc:kap:eurfin:v:9:y:2005:i:1:p:97-137

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Web page: http://springerlink.metapress.com/link.asp?id=111870

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Cited by:
  1. Ascari, Guido & Rankin, Neil, 2007. "Perpetual youth and endogenous labor supply: A problem and a possible solution," Journal of Macroeconomics, Elsevier, vol. 29(4), pages 708-723, December.
  2. Guillermo Benavides Perales & Israel Felipe Mora Cuevas, 2008. "Parametric vs. non-parametric methods for estimating option implied risk-neutral densities: the case of the exchange rate Mexican peso – US dollar," Ensayos Revista de Economia, Universidad Autonoma de Nuevo Leon, Facultad de Economia, vol. 0(1), pages 33-52, May.
  3. William R. Emmons & Aeimit K. Lakdawala & Christopher J. Neely, 2006. "What are the odds? option-based forecasts of FOMC target changes," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 543-562.

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