The forecast ability of risk-neutral densities of foreign exchange

Ben Craig and Joachim Keller

No 2005,05, Discussion Paper Series 2: Banking and Financial Studies from Deutsche Bundesbank, Research Centre

Abstract: We estimate the process underlying the pricing of American options by using higher-order lattices combined with a multigrid method. This paper also tests whether the risk-neutral densities given from American options provide a good forecasting tool. We use a nonparametric test of the densities that is based on the inverse probability functions and is modified to account for correlation across time between our random variables, which are uniform under the null hypothesis. We find that the densities based on the Americanoption markets for foreign exchange do quite well for the forecasting period over which the options are thickly traded. Further, simple models that fit the densities do about as well as more sophisticated models. Keywords: Risk-neutral densities from option prices, American exchange rate options, Evaluating Density Forecasts, Pentionominal tree, Density evaluation, Overlapping data problem

Keywords: Risk-neutral densities from option prices; American exchange rate options; Evaluating Density Forecasts; Pentionominal tree; Density evaluation (search for similar items in EconPapers)
JEL-codes: C52 C63 F31 F47 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm, nep-fmk, nep-for, nep-ifn and nep-mst
Date: Written 2005
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