Inflation options price fatter tails than normal models capture
Euro-area inflation options imply more extreme outcomes than a normal model captures, Diego Bonelli finds in a Bank of Spain paper. Longer-horizon priced risks moved less than near-term risks during the inflation cycle.
Near-term risks change most
SABR and nonparametric estimates both recover skewed, fat-tailed inflation distributions; SABR produces smoother daily estimates.
The balance of risks subtracts the probability below the 2 percent target from that above it.
Its one-year value rose from -60.8 percentage points in 2009–2020 to 40.1 in 2021–2022; the five-years-in-five-years forward measure moved from -15.3 to 2.4. On matched survey dates, SABR balances averaged -32.2, -34.4 and -24.3 points at one, two and five years.
European Central Bank (ECB) Survey of Professional Forecasters readings were -28.3, -26.1 and -15.3, respectively.
The resulting gaps were -3.9, -8.3 and -9.0 points, based on 106, 106 and 103 matched releases.
The survey comparison does not establish relative forecasting performance.
Prices are not pure expectations
Bonelli uses Bloomberg cap and floor quotes covering 4,367 trading days from October 5, 2009 to June 30, 2026.
Contracts reference Eurostat inflation excluding tobacco.
Both non-normal methods are compared with a normal benchmark using identical quotes.
Forward distributions combine option-implied marginals with a Student-t copula calibrated from historical swap-rate changes.
Swap rates anchor distribution means.
Spot densities include risk compensation; forward densities are constructions, not joint risk-neutral distributions directly identified from option prices.
Anchoring claims remain limited
Smaller long-horizon movements are not a direct test of anchored inflation expectations.
The balance-of-risks index mainly tracks distribution location, while tail probabilities better expose differences between models.
Evidence remains in-sample and largely reflects one inflation cycle.