NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Economics of Options-Implied Inflation Probability Density Functions

Yuriy Kitsul, Jonathan H. Wright

NBER Working Paper No. 18195
Issued in June 2012
NBER Program(s):   ME

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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Document Object Identifier (DOI): 10.3386/w18195

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