Measuring Euro-Area Inflation Risk with Options: Market-Implied Distribution and Balance of Risks
Series: Occasional Papers. 2625.
Author: Diego Bonelli
Inflation
- European Union
- Financial risks
- Quantitative methods
Full document
Abstract
Rationale
Inflation options contain information about the entire distribution of future inflation, but extracting that information requires methodological choices regarding volatility modelling, tail behaviour and forward-distribution construction. This paper compares alternative parametric and nonparametric approaches for recovering market-implied inflation distributions and assesses how those choices affect the resulting measures of inflation risk.
Takeaways
- The paper develops a framework to recover risk-neutral inflation distributions from euro-area inflation options at both spot and forward horizons.
- Parametric (SABR) and nonparametric approaches deliver broadly similar estimates of skewness, kurtosis and tail probabilities, suggesting that these features originate in option prices rather than in a particular modelling choice.
- SABR provides a more stable and parsimonious representation of the inflation-option smile, making it well suited for the construction of continuous inflation-risk indicators.