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Inflation Risk Premium Derived From Foreign Exchange Options

Author

Listed:
  • Eddy Azoulay

    (Bank of Israel)

  • Menachem Brenner
  • Yoram Landskroner

Abstract

Inflation expectations are a key economic variable for investors in capital markets and for economic policy decision makers. One of the widely used sources for deriving inflation expectations is market price of bonds. The yield differential between nominal bonds and inflation-indexed (linked) bonds is taken to be an estimate of expected inflation. The problem is, however, that in a risk-averse world the yield differential includes an inflation risk premium and thus the yield differential provides an upward bias of inflation expectations. The novelty of our paper is that we estimate this risk premium using the volatility implied in options prices. In the absence of a market in options on inflation we use prices of foreign currency options to estimate this risk premium. The theoretical foundation of our methodology is purchasing power parity theory. The Israeli financial market has both, an inflation-linked and unlinked bond market and an active FX options market. Using data from both markets we find a statistically and economically significant inflation risk premium.

Suggested Citation

  • Eddy Azoulay & Menachem Brenner & Yoram Landskroner, 2007. "Inflation Risk Premium Derived From Foreign Exchange Options," Bank of Israel Working Papers 2007.01, Bank of Israel.
    • Handle: RePEc:boi:wpaper:2007.01
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    File URL: https://boiwebrepec.azurefd.net/RePEc/boi/wpaper/WP_2007.01.pdf
    File Function: First version, 2007
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    More about this item

    Keywords

    Inflation expectations; Inflation risk premium; Inflation indexed bonds; foreign exchange options; Purchasing Power Parity; Error Correction Model;
    All these keywords.

    JEL classification:

    • 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
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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