IMF Working Papers

A New Framework to Estimate the Risk-Neutral Probability Density Functions Embedded in Options Prices

By Kevin C Cheng

August 1, 2010

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Kevin C Cheng. A New Framework to Estimate the Risk-Neutral Probability Density Functions Embedded in Options Prices, (USA: International Monetary Fund, 2010) accessed September 19, 2024
Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

Building on the widely-used double-lognormal approach by Bahra (1997), this paper presents a multi-lognormal approach with restrictions to extract risk-neutral probability density functions (RNPs) for various asset classes. The contributions are twofold: first, on the technical side, the paper proposes useful transformation/restrictions to Bahra’s original formulation for achieving economically sensible outcomes. In addition, the paper compares the statistical properties of the estimated RNPs among major asset classes, including commodities, the S&P 500, the dollar/euro exchange rate, and the US 10-year Treasury Note. Finally, a Monte Carlo study suggests that the multi-lognormal approach outperforms the double-lognormal approach.

Subject: Asset prices, Commodities, Commodity prices, Futures, Options

Keywords: WP

Publication Details

  • Pages:

    31

  • Volume:

    ---

  • DOI:

    ---

  • Issue:

    ---

  • Series:

    Working Paper No. 2010/181

  • Stock No:

    WPIEA2010181

  • ISBN:

    9781455202157

  • ISSN:

    1018-5941