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Inflation Risk Premium Implied by Options

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One of the commonly used estimates of expected inflation is the yield differential between nominal bonds and inflation-indexed bonds (breakeven inflation). Breakeven inflation is however a biased estimate of expected inflation because it includes an inflation risk premium (IRP). The novelty of our approach is that we estimate the IRP using the volatility implied from foreign exchange (FX) option prices combined with a price of risk extracted from stock prices. Purchasing Power Parity theory provides the linkage between inflation and the foreign exchange rate. Using data from the Israeli government bond market, which has a long history of liquid markets in inflation-linked and nominal bonds as well as an active FX options market, we find a statistically and economically significant positive inflation risk premium.

 JEL Classification: E31, E32, E51

Key words: Inflation expectations, inflation-indexed (linked) bonds, Inflation risk premium, foreign exchange options



Inflation expectations are a key variable for investors in capital markets and also play an important role in determining monetary policy in many countries, especially in countries with strong and independent central banks. In this paper we derive a market-based measure of unbiased inflation expectations, net of inflation risk premium (IRP), using data on inflation indexed government bonds, nominal government bonds and options on foreign exchange (FX) in lieu of options on inflation which are not available. A number of approaches are used to forecast inflation. Most models are econometric models, both structural and purely statistical. These models, however, rely on historic data and are not forward looking. Another source of inflation forecasts are surveys of professional analysts and economists. 1 Surveys are, however, based on samples that are usually small and therefore might not be representative of market expectations. In economies where inflation-indexed government bonds have been issued (e.g. TIPS in the U.S.) inflation expectations are derived from the yield differential between nominal bonds and inflation – indexed (real) government bonds. This estimate is referred to as breakeven inflation (BEI). 2 Inflation indexed bonds exist now in many countries.3 The BEI as a measure of inflation expectations is used by central banks in a number of countries (e.g., the Federal Reserve, the Bank of England, Bank of Canada and the Bank of Israel) 4 . The advantages of these estimates are that they are market based, forward looking, can be computed continuously and can provide the entire term structure of inflation expectations. Numerous papers have estimated inflation expectations in different countries from nominal and inflation indexed bonds. 5

–Eddy Azoulay, Bank of Israel; Menachem Brenner* Stern School of Business, New York University; Yoram Landskroner, College for Academic Studies Or Yehuda And School of Business dministration The Hebrew University of Jerusalem; Roy Stein, Bank of Israel

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We would like to thank Meir Sokoler, Michael Beenstock, Ami Barnea, Alex Ilek, Bill Silber, Paul Wachtel and participants of the Bank of Israel Reaserch Department seminar for their helpful comments. Thanks also to Helena Pompushko and Angela Barenholtz for their assistance.

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