Implicit Entropic Market Risk-Premium from Interest Rate Derivatives

Abstract

Implicit in interest rate derivatives are Arrow–Debreu prices (or state price densities, SPDs) that contain funda- mental information for risk and portfolio management in interest rate markets. To extract such information from interest rate derivatives, we propose a nonparametric method to estimate state prices based on the minimization of the Cressie–Read (Entropic) family function between potential SPDs and the empirical probability measure. An empirical application of the method, in the US interest rates and derivatives market, shows that the entropic based risk-neutral density measure highlight potential risks previous to the 2007/2008 financial crisis, and the potential arbitrage burden during the Quantitative Easing period.

Keywords: Risk management, Risk analysis, Nonparametric Asset Pricing, State Price Density, Interest Rate Derivatives.

JEL Classification: C14, G12, G13, G14, G18