Risk premia implied by derivative prices

Abstract: The thesis investigates the potential to recover the real world probabilities of an underlying asset from derivative prices by using the recovery approach developed in (Carr & Yu, 2012) and (Ross, 2011). For this purpose the VIX Index and US Treasury bills are used to recover the VIX dynamics and the short rate dynamics under the real world probability measure. The approach implies that VIX and its derivatives has a risk premium equal to zero contradicting empirical evidence of a substantial negative risk premium. In fact, we show that for any asset unrelated to the short rate its risk premium is zero. In the case of recovering the short rate, the CIR model is calibrated to the US zero coupon Treasury yield curve. The predictions of the recovered CIR process is benchmarked against the risk neutral CIR process and a naive predictor. The recovered process is found to outperform the risk neutral process suggesting that the recovery step was successful. However, it underperforms the naive process in its predictions.