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The Economics of Options-Implied Inflation Probability Density Functions

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  • Jonathan Wright

    (Johns Hopkins University)

  • Yuriy Kitsul

    (Federal Reserve Board)

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    Abstract

    Recently a market in options based on CPI 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 pdfs respond to news announcments, and ÃÂfind that the implied odds of deflation are sensitive to certain macroeconomic news releases. We compare the option-implied probability densities with those obtained by time series methods, and use this information to construct empirical pricing kernels. 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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    File URL: http://www.economicdynamics.org/meetpapers/2012/paper_174.pdf
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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 174.

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    Date of creation: 2012
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    Handle: RePEc:red:sed012:174

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    References

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    1. Ray Fair, 2003. "Events that Shook the Market," Yale School of Management Working Papers ysm307, Yale School of Management.
    2. Jens H. E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2008. "Inflation expectations and risk premiums in an arbitrage-free model of nominal and real bond yields," Working Paper Series 2008-34, Federal Reserve Bank of San Francisco.
    3. Olesya V. Grishchenko & Joel M. Vanden & Jianing Zhang, 2011. "The information content of the embedded deflation pption in TIPS," Finance and Economics Discussion Series 2011-58, Board of Governors of the Federal Reserve System (U.S.).
    4. Jonathan H. Wright, 2011. "What does Monetary Policy do to Long-Term Interest Rates at the Zero Lower Bound?," NBER Working Papers 17154, National Bureau of Economic Research, Inc.
    5. Hanno Lustig, 2011. "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle," 2011 Meeting Papers 1443, Society for Economic Dynamics.
    6. Jens H.E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2012. "Pricing deflation risk with U.S. Treasury yields," Working Paper Series 2012-07, Federal Reserve Bank of San Francisco.
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    Cited by:
    1. Matthew D. Raskin, 2013. "The effects of the Federal Reserve's date-based forward guidance," Finance and Economics Discussion Series 2013-37, Board of Governors of the Federal Reserve System (U.S.).

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