Summary
Market-implied probabilities are just as the name sounds: weights that the market is assigning an event based upon current prices of financial instruments. By deriving these probabilities, we can gain an understanding of the market’s aggregate forecast for certain events. Fortunately, the Federal Reserve Bank of Minneapolis provides a very nice tool for visualizing market-implied probabilities without us having to derive them.[1]
- Using historical data from the options market along with realized subsequent returns, we can translate risk-neutral probabilities into real-world probabilities.
- Market implied probabilities are risk-neutral probabilities derived from the derivatives market. They incorporate both the probability of an event happening and the equilibrium cost associated with it.
- Since investors have the flexibility of designing their own portfolios, real-world probabilities of event occurrences are more relevant to individuals than are risk-neutral probabilities.
- With a better handle on the real-world probabilities, investors can make portfolio decisions that are in line with their own goals and risk tolerances, leaving the aggregate decision making to the policy makers.
For example, say that I am concerned about inflation over the next 5 years. I can see how the probability of a large increase has been falling over time and how the probability of a large decrease has fallen recently, with both currently hovering around 15%.
Historical Market Implied Probabilities of Large Moves in Inflation
Source: Minneapolis Federal Reserve
I can also look at the underlying probability distributions for these predictions, which are derived from the derivatives market, and compare the changes over time.......MUCH MORE
