The Economics of Options-Implied Inflation Probability Density Functions

43 Pages Posted: 29 Jun 2012 Last revised: 21 Mar 2021

See all articles by Yuriy Kitsul

Yuriy Kitsul

Board of Governors of the Federal Reserve System

Jonathan H. Wright

Johns Hopkins University - Department of Economics

Date Written: June 2012

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 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.

Suggested Citation

Kitsul, Yuriy and Wright, Jonathan H., The Economics of Options-Implied Inflation Probability Density Functions (June 2012). NBER Working Paper No. w18195, Available at SSRN: https://ssrn.com/abstract=2096008

Yuriy Kitsul (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Jonathan H. Wright

Johns Hopkins University - Department of Economics ( email )

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