TY  - JOUR
AU  - Kitsul,Yuriy
AU  - Wright,Jonathan H.
TI  - The Economics of Options-Implied Inflation Probability Density Functions
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 18195
PY  - 2012
Y2  - June 2012
UR  - http://www.nber.org/papers/w18195
L1  - http://www.nber.org/papers/w18195.pdf
N1  - Author contact info:
Yuriy Kitsul
Federal Reserve Board
20th and C Sts NW
Washington DC 20551
E-Mail: yuriy.kitsul@frb.gov

Jonathan H. Wright
Department of Economics
Johns Hopkins University
3400 N. Charles Street
Baltimore, MD 21218
Tel: 410/516-5728
Fax: 410/516-7600
E-Mail: wrightj@jhu.edu
AB  - 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.
ER  -