Inflation Expectations Derived from Foreign

24 Pages Posted: 3 Nov 2008

See all articles by Eddy Azoulay

Eddy Azoulay

affiliation not provided to SSRN

Menachem Brenner

New York University (NYU) - Department of Finance

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking; New York University (NYU) - Leonard N. Stern School of Business

Date Written: May 2008

Abstract

Inflation expectations are a key economic variable for investors in capital markets and for economic policy decision makers. One of the widely used sources for deriving inflation expectations are market prices of bonds. The yield differential between nominal bonds and inflation-indexed (linked) bonds is taken to be an estimate of expected inflation. The problem is however that in a risk averse world the yield differential includes an inflation risk premium and thus the yield differential provides an upward bias of inflation expectations. The novelty of our paper is that we estimate this risk premium using volatility implied in options prices. In the absence of a market in options on inflation we use prices of foreign currency options to estimate this risk premium. The theoretical foundation of our methodology is purchasing power parity theory. The Israeli financial market has both, an inflation linked and non linked bond market and an active FX options market. Using data from both markets we find a statistically and economically significantinflation risk premium.

Suggested Citation

Azoulay, Eddy and Brenner, Menachem and Landskroner, Yoram, Inflation Expectations Derived from Foreign (May 2008). NYU Working Paper No. FIN-07-001, Available at SSRN: https://ssrn.com/abstract=1293135

Eddy Azoulay (Contact Author)

affiliation not provided to SSRN

Menachem Brenner

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0323 (Phone)
212-995-4233 (Fax)

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking ( email )

Mount Scopus
Jerusalem, 91905
Israel

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

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