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The economics of options-implied inflation probability density functions

Author Info

  • 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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    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
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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

    Find related papers by JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

    References listed on IDEAS
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. 5-Year Deflation Probability Moves Off Zero
      by macroblog in Macroblog on 2015-09-04 16:34:05
    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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    Cited by:

    1. Grishchenko, Olesya V. & Vanden, Joel M. & Zhang, Jianing, 2016. "The informational content of the embedded deflation option in TIPS," Journal of Banking & Finance, Elsevier, vol. 65(C), pages 1-26.
    2. Jens Hilscher & Alon Raviv & Ricardo Reis, 2014. "Inflating Away the Public Debt? An Empirical Assessment," Working Papers 74, Brandeis University, Department of Economics and International Businesss School.
    3. Leonardo Melosi & Francesco Bianchi, 2015. "Escaping the Great recession," 2015 Meeting Papers 1035, Society for Economic Dynamics.
    4. Dovern, Jonas & Manner, Hans, 2016. "Order Invariant Evaluation of Multivariate Density Forecasts," Working Papers 0608, University of Heidelberg, Department of Economics.
    5. Scharnagl, Michael & Stapf, Jelena, 2015. "Inflation, deflation, and uncertainty: What drives euro-area option-implied inflation expectations, and are they still anchored in the sovereign debt crisis?," Economic Modelling, Elsevier, vol. 48(C), pages 248-269.
    6. Armenter, Roc, 2015. "On the use of market-based probabilities for policy decisions," Working Papers 15-44, Federal Reserve Bank of Philadelphia.
    7. Scharnagl, Michael & Stapf, Jelena, 2014. "Inflation, deflation, and uncertainty: What drives euro area option-implied inflation expectations and are they still anchored in the sovereign debt crisis?," Discussion Papers 24/2014, Deutsche Bundesbank, Research Centre.
    8. 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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