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Central Bank Policy Impacts on the Distribution of State Prices for Future Interest Rates, 2003–2022

Douglas T. Breeden and Robert H. Litzenberger
The Journal of Fixed Income 30th Anniversary Special Issue 2022, 32 (2) 64-92; DOI: https://doi.org/10.3905/jfi.2022.1.145
Douglas T. Breeden
is the William W. Priest Professor of Finance in the Fuqua School of Business at Duke University in Durham, NC
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Robert H. Litzenberger
is the Edward Hopkinson Professor of Investment Banking Emeritus in the Wharton School at University of Pennsylvania in Philadelphia, PA
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Abstract

In this article, we extend the 1978 Breeden–Litzenberger method of extracting state prices from option prices, showing how portfolios of butterfly spreads can be combined with right and left tail spreads to nonparametrically extract discrete state prices from option prices. We derive how those state prices should be biased estimates of true, objective probabilities. For interest rate options, we show that the biases can vary predictably over time (sometimes too high, sometimes too low), as the correlation of interest rates with consumption and wealth has changed signs over time. Consumption betas and proper risk premiums on bonds and of their state prices are at times predictably positive and at times predictably negative. We apply our technique to provide a brief 20-year history of central bank intervention impacts in the US, UK, and Eurozone from 2003 to 2022. Movements in state prices are quite large in the Financial Panic of 2008–2009, as well as in the European Sovereign Debt Crisis of 2010–2013, with Brexit and the Trump elections in 2016, and with the coronavirus pandemic in 2020–2021. Tapering in 2013 and 2022 and liftoffs in rates in 2015 and 2022 were shown to strongly shift state price distributions back toward the symmetry of 2003–2007. We show that central banks dramatically impacted entire state price distributions, not just levels of rates.

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The Journal of Fixed Income: 32 (2)
The Journal of Fixed Income
Vol. 32, Issue 2
30th Anniversary Special Issue 2022
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Central Bank Policy Impacts on the Distribution of State Prices for Future Interest Rates, 2003–2022
Douglas T. Breeden, Robert H. Litzenberger
The Journal of Fixed Income Sep 2022, 32 (2) 64-92; DOI: 10.3905/jfi.2022.1.145

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Central Bank Policy Impacts on the Distribution of State Prices for Future Interest Rates, 2003–2022
Douglas T. Breeden, Robert H. Litzenberger
The Journal of Fixed Income Sep 2022, 32 (2) 64-92; DOI: 10.3905/jfi.2022.1.145
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  • Article
    • Abstract
    • RESULT 1: TRIANGLES, TRAPEZOIDS AND TAIL SPREADS: DECOMPOSING OPTION PAYOFFS
    • RESULT 2: PRICES OF BUTTERFLY TRIANGULAR PAYOFFS EQUAL “DIGITAL OPTION” PRICES
    • RESULT 3: STATE PRICES HAVE BIASES AS ESTIMATES OF “TRUE PROBABILITIES”
    • RESULT 4: CHANGING REAL BETAS FOR NOMINAL BONDS 1962–2021 MEANS CHANGING BIASES OF INTEREST RATE STATE PRICES AS FORECASTS OF PROBABILITIES
    • RESULT 5: US CENTRAL BANK POLICY IMPACTS ON INTEREST RATE INSURANCE PRICES
    • 2010–2013: ECB POLICY IMPACTS IN THE EUROPEAN SOVEREIGN DEBT CRISIS
    • 2015–2019: YELLEN FED EXECUTES LIFTOFF. ECB QE
    • 2020–2022 CORONAVIRUS PANDEMIC, BRIEF HUGE GLOBAL RECESSIONS, AND RECOVERY
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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