Inflation risk premium implied by options

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. (C) 2013 Elsevier Inc. All rights reserved.