Reading the Smile: The Message Conveyed by Methods Which Infer Risk Neutral

Eric Jondeau and Michael Rockinger ()

Working papers from Banque de France

Abstract: In this study we compare the quality and information content of risk neutral densities obtained by various methods. We consider a non-parametric method based on a mixture of log-normal densities, the semi-parametric ones based on an Hermite approximation of Madan and Milne, or based on an Edgeworth expansion of Jarrow and Rudd, the parametric approach of Malz which assumes a jump-diffusion for the underlying process, and eventually Heston's approach assuming a stochastic volatility model. We apply those models on FRF/DEM exchange rate options for two dates, for various maturities. Models differ when important news hit the market (here the 1997 snap elections). The non-parametric model provides a good fit to options prices but is unable under critical circumstances to provide as much information about market participants expectations than Malz's jump-diffusion model.

Keywords: Risk neutral density; Option pricing; Exchange rate option. (search for similar items in EconPapers)
JEL-codes: C52 F31 F33 G14 (search for similar items in EconPapers)
Pages: 27 pages
Date: 1998
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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