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The Economics of Options-Implied Inflation Probability Density Functions

  • Yuriy Kitsul
  • Jonathan H. Wright

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 announcements, and find 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18195.

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Date of creation: Jun 2012
Date of revision:
Publication status: published as "The Economics of Options-Implied Inflation Probability Density Functions," Journal of Financial Economics, vol. 110, no. 3, pp. 696-711.
Handle: RePEc:nbr:nberwo:18195
Note: ME
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  1. Carolin E. Pflueger & Luis M. Viceira, 2011. "Inflation-Indexed Bonds and the Expectations Hypothesis," NBER Working Papers 16903, National Bureau of Economic Research, Inc.
  2. Hanno Lustig, 2011. "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle," 2011 Meeting Papers 1443, Society for Economic Dynamics.
  3. Olesya V. Grishchenko & Jing-zhi Huang, 2012. "Inflation risk premium: evidence from the TIPS market," Finance and Economics Discussion Series 2012-06, Board of Governors of the Federal Reserve System (U.S.).
  4. Neil Shephard & Yashurio Omori, 2004. "Stochastic volatility with leverage: fast likelihood inference," Economics Series Working Papers 2004-FE-16, University of Oxford, Department of Economics.
  5. Ray C. Fair, 2002. "Events That Shook the Market," The Journal of Business, University of Chicago Press, vol. 75(4), pages 713-732, October.
  6. 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.
  7. 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.).
  8. Giorgio E. Primiceri, 2005. "Time Varying Structural Vector Autoregressions and Monetary Policy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 821-852.
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