Estimating Option Implied Risk Neutral Densities
Author | : Greg Orosi |
Publisher | : |
Total Pages | : |
Release | : 2019 |
ISBN-10 | : OCLC:1304320352 |
ISBN-13 | : |
Rating | : 4/5 (52 Downloads) |
Download or read book Estimating Option Implied Risk Neutral Densities written by Greg Orosi and published by . This book was released on 2019 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: In this paper, we propose a novel parametric approach to extract the implied risk-neutral density function from a cross-section of call option prices. The method is based on the framework proposed by Orosi (2011), who presents a multi-parameter extension of the models of Figlewski (2002) and Henderson, Hobson, and Kluge (2007). By choosing a proper functional form, we show that well-behaved risk neutral densities can be generated by imposing restrictions on the parameters of the model. The results of our numerical experiments demonstrate that the method is capable of extracting risk neutral densities with complex characteristics. Moreover, we demonstrate the pricing performance of our method by generating arbitrage-free call option prices that can be used to produce well-behaved densities from S&P 500 Index options. Additionally, the model is extremely easy to implement and calibrate, and further extensions are straightforward. NOTE: This is a preprint. The published version contains, in addition to extensive empirical tests, a generalization of the main model applicable to defaultable stocks, and an intuitive explanation of the choice of the model parameters.