Inflation Watch – How are markets pricing inflation in 1 year?
Option premiums reveal underlying risk-neutral expectations about the underlying security at expiry, and we can hence use premiums on inflation caps and floors (in essence call/put options on YoY inflation levels) to estimate probability distributions for USD, EUR and GBP 1Y inflation levels, using the methodology from “THE ECONOMICS OF OPTIONS-IMPLIED INFLATION PROBABILITY DENSITY FUNCTIONS”.
The market for inflation caps/floors is relatively small, but the data provides information despite the illiquidity – from the paper:
“The nominal Treasury market is far more liquid than the TIPS market, which is in turn more liquid than the market for inflation swaps, and that is in turn more liquid than the market for inflation floors and caps […] The dollar trading volumes in inflation derivatives are minuscule relative to the Treasury market, but still big enough to presumably reflect the beliefs of traders in this market”
The small size of the market also implies that quoted prices are of mixed quality. Hence, we have been forced to rely on Bloomberg’s volatility-based pricing (for strike levels -1% to 5%), so take the absolute values with a pinch of salt – it’s the relative differences between markets that matter.
For those who’re interested, the method is – in short – to form butterfly spreads between different strike levels which make one able to isolate the risk-neutral probability of inflation landing at that strike level (assuming that inflation moves in integers). Remember that risk-neutral probabilities are NOT real probabilities because markets are never truly risk-neutral.
We’ll soon copy this method to other more liquid and tradable instruments, so stay tuned!
Let’s jump to the charts!
Option premiums allow one to derive risk-neutral probabilities for the underlying security at expiry. How are these probabilities looking for USD, EUR- and GBP inflation?