DENSITY FUNCTIONALS, WITH AN OPTION-PRICING APPLICATION

Karim M. Abadir and Michael Rockinger ()

Econometric Theory, 2003, vol. 19, issue 5, 778-811

Abstract: We present a method of estimating density-related functionals, without prior knowledge of the density's functional form. The approach revolves around the specification of an explicit formula for a new class of distributions that encompasses many of the known cases in statistics, including the normal, gamma, inverse gamma, and mixtures thereof. The functionals are based on a couple of hypergeometric functions. Their parameters can be estimated, and the estimates then reveal both the functional form of the density and the parameters that determine centering, scaling, etc. The function to be estimated always leads to a valid density, by design, namely, one that is nonnegative everywhere and integrates to 1. Unlike fully nonparametric methods, our approach can be applied to small datasets. To illustrate our methodology, we apply it to finding risk-neutral densities associated with different types of financial options. We show how our approach fits the data uniformly very well. We also find that our estimated densities' functional forms vary over the dataset, so that existing parametric methods will not do uniformly well.We thank Hans-Jürg Büttler, Aleš Černý, Tony Culyer, Les Godfrey, David Hendry, Sam Kotz, Steve Lawford, Peter Phillips, Bas Werker, and three anonymous referees for their comments. We also thank for their feedback the participants at the seminars and conferences where this paper has been invited, in particular the 1998 CEPR Finance Network Workshop, the 1998 METU conference, the 1998 FORC (Warwick) conference “Options: Recent Advances,” Money Macro & Finance Group, the Swiss National Bank, Imperial College, Tilburg University, Université Libre de Bruxelles, the University of Oxford, Southampton University, and UMIST. The first author acknowledges support from the ESRC (UK) grant R000239538. The second author acknowledges help from the HEC Foundation and the European Community TMR grant “Financial Market Efficiency and Economic Efficiency.” This paper was written when the second author was affiliated with HEC-Paris.

Date: 2003
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