Retrieving risk neutral densities from European option prices based on the principle of maximum entropy

Leonidas Rompolis

Journal of Empirical Finance, 2010, vol. 17, issue 5, 918-937

Abstract: This paper suggests a new method of implementing the principle of maximum entropy to retrieve the risk neutral density of future stock, or any other asset, returns from European call and put prices. The method maximizes the entropy measure subject to risk neutral moment constraints in place of option prices used by previous studies. These moments can be retrieved from market option prices at each point of time, in a first step. Compared to other existing methods of retrieving the risk neutral density based on the principle of maximum entropy, the benefits of the method that the paper suggests is the use of all the available information provided by the market more efficiently. To evaluate the performance of the suggested method, the paper compares it to other risk neutral density estimation techniques by conducting a simulation study and carrying out some crucial empirical exercises.

Keywords: Maximum; entropy; Risk; neutral; density; Risk; neutral; moments (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (13)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:17:y:2010:i:5:p:918-937

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