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Inflation risk premium implied by options

Author

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  • Azoulay, Eddy
  • Brenner, Menachem
  • Landskroner, Yoram
  • Stein, Roy

Abstract

One of the commonly used estimates of expected inflation is the yield differential between nominal bonds and inflation-indexed bonds (breakeven inflation). Breakeven inflation is however a biased estimate of expected inflation because it includes an inflation risk premium (IRP). The novelty of our approach is that we estimate the IRP using the volatility implied from foreign exchange (FX) option prices combined with a price of risk extracted from stock prices. Purchasing Power Parity theory provides the linkage between inflation and the foreign exchange rate. Using data from the Israeli government bond market, which has a long history of liquid markets in inflation-linked and nominal bonds as well as an active FX options market, we find a statistically and economically significant positive inflation risk premium.

Suggested Citation

  • Azoulay, Eddy & Brenner, Menachem & Landskroner, Yoram & Stein, Roy, 2014. "Inflation risk premium implied by options," Journal of Economics and Business, Elsevier, vol. 71(C), pages 90-102.
    • Handle: RePEc:eee:jebusi:v:71:y:2014:i:c:p:90-102
    DOI: 10.1016/j.jeconbus.2013.06.001
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    References listed on IDEAS

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    Cited by:

    1. Covarrubias, Enrique & Hernández-del-Valle, Gerardo, 2016. "Inflation expectations derived from a portfolio model," MPRA Paper 69489, University Library of Munich, Germany.

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    More about this item

    Keywords

    Inflation expectations; Inflation-indexed (linked) bonds; Inflation risk premium; Foreign exchange options;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers

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