The purpose of this paper is to bridge two strands of the literature, one pertaining to the objective or physical measure used to model an underlying asset and the other pertaining to the risk-neutral measure used to price derivatives. We propose a generic procedure using simultaneously the fundamental price, St, and a set of option contracts [(σitI)i=1,m] where m⩾1 and σitI is the Black–Scholes implied volatility. We use Heston's (1993. Review of Financial Studies 6, 327–343) model as an example, and appraise univariate and multivariate estimation of the model in terms of pricing and hedging performance. Our results, based on the S&P 500 index contract, show dominance of univariate approach, which relies solely on options data. A by-product of this finding is that we uncover a remarkably simple volatility extraction filter based on a polynomial lag structure of implied volatilities. The bivariate approach, involving both the fundamental security and an option contract, appears useful when the information from the cash market reflected in the conditional kurtosis provides support to price long term.

We use information in the term structure of survey-based forecasts of inflation to estimate a factor hidden in the nominal yield curve. We construct a model that accommodates forecasts over multiple horizons from multiple surveys and Treasury real and nominal yields by allowing for differences between risk-neutral, subjective, and objective probability measures. We establish that model-based inflation expectations are driven by inflation, output, and one latent factor. We find that this factor affects inflation expectations at all horizons but has almost no effect on the nominal yields; that is, the latent factor is hidden. We show that this hidden factor is not related to either current and past inflation or the standard set of macro variables studied in the literature. Consistent with the theoretical property of a hidden factor, our model outperforms a standard macro-finance model in its forecasting of inflation and yields.

Sovereign credit default swap quanto spreads tell us how financial markets view the interaction between a country’s likelihood of default and associated currency devaluations (the Twin Ds). A no-arbitrage model applied to the term structure of eurozone quanto spreads can isolate the Twin Ds and can gauge the associated risk premiums. Conditional on the occurrence of default, the true and risk-adjusted one-week probabilities of devaluation are 42% (2%) and 90% (55%) for the core (periphery) countries. The weekly risk premium for euro devaluation in case of default for the core (periphery) exceeds the regular currency premium by up to 18 (13) basis points.

We explore the term structures of claims to a variety of cash flows, namely, US government bonds (claims to dollars), foreign government bonds (claims to foreign currency), inflation-adjusted bonds (claims to the price index), and equity (claims to future equity indexes or dividends). The average term structures reflect the dynamics of the dollar pricing kernel, cash flow growth, and the interaction between the two. We use an affine model to illustrate how these two components can deliver term structures with a wide range of levels and shapes. Finally, we calibrate a representative agent economy to show that the evidence is consistent with the equilibrium models.