Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia

56 Pages Posted: 26 Jun 2003

See all articles by Peter Hördahl

Peter Hördahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific

David Vestin

European Central Bank (ECB)

Date Written: September 2003

Abstract

This paper examines differences between risk-neutral and objective probability densities of future interest rates. The identification and quantification of these differences are important when risk-neutral densities (RNDs), such as option-implied RNDs, are used as indicators of actual beliefs of investors. We employ a multi-factor essentially affine modeling framework applied to German time-series and cross-section term structure data in order to identify both the risk-neutral and the objective term structure dynamics. We find important differences between risk-neutral and objective distributions due to risk premia in bond prices. Moreover, the estimated premia vary over time in a quantitatively significant way, which implies that the differences between the objective and the risk-neutral distributions also vary over time. We conclude that one should be cautious in interpreting RNDs as representing the true expectations of market participants. The method used in this paper provides an alternative approach to identifying probabilities of future interest rates.

JEL Classification: G12, E43

Suggested Citation

Hoerdahl, Peter and Vestin, David, Interpreting Implied Risk-Neutral Densities: The Role of Risk Premia (September 2003). Available at SSRN: https://ssrn.com/abstract=407730 or http://dx.doi.org/10.2139/ssrn.407730

Peter Hoerdahl (Contact Author)

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific ( email )

78th floor, Two International Finance Centre
8 Finance Street, Central
Hong Kong

David Vestin

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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