Finance Brown Bag Seminar
Speaker: Vesela Ivanova, Goethe University
Topic: "Getting real forecasts, state price densities and risk premium from Euribor options" (joint work with Josep Maria Puigvert Gutierrez, ECB)
In this paper we study the development of interest rate risk premium and option implied state price densities in the Euribor futures option market. Using parametric and nonparametric statistical calibration, we transform the risk-neutral option implied densities for the Euribor futures rate into real-world densities. We investigate the period from the introduction of the Euro in 1999 until September 2012. The estimated densities are used to provide a measure for the interest rate risk premium and state prices implicit in the futures market. We find that although we cannot reject the forecasting power of the risk-neutral densities, the real-world forecasts are superior. The futures state price densities exhibit a U-shaped curve suggesting that investors price higher both states when rates are very high and very low compared to the expected spot rate. As a result, we find a significant short rate risk premium in the market, which is negative on average but changes sign with the outburst of the US sub-prime crisis in 2008. We further document that the short-rate risk premium is a strong predictor of aggregate market instability in the Euro Area.