Interest rate forecasts, state price densities and risk premium from Euribor options

In this paper we study option-implied interest rate forecasts and the development of risk premium and state prices in the Euribor futures option market. Using parametric and non-parametric 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 December 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 the real-world option-implied distributions can be used to forecast the futures rate, while the forecasting ability of the risk-neutral distributions is rejected. The state price densities in the market show a U-shaped curve suggesting that investors price higher states with high and low rates compared to the expected spot rate. However, we show that, in general, state prices have a more pronounced right tail, implying that investors are more risk averse to increasing interest rates. We also document a negative market price of interest rate risk which generates positive premium for the futures contract.