Parametric vs. non-parametric methods for estimating option implied risk-neutral densities: the case of the exchange rate Mexican peso – US dollar

Guillermo Benavides Perales () and Israel Felipe Mora Cuevas
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Guillermo Benavides Perales: Banco de México, Dirección General de Investigación Económica and Tecnológico de Monterrey, Campus Ciudad de México.
Israel Felipe Mora Cuevas: University of Essex

Ensayos Revista de Economia, 2008, vol. XXVII, issue 1, 33-52

Abstract: This research paper presents statistical comparisons between two methods that are commonly used to estimate option implied Risk-Neutral Densities (RND). These are: 1) mixture of lognormals (MXL); and, 2) volatility function technique (VFT). The former is a parametric method whilst the latter is a non-parametric approach. The RNDs are extracted from over-thecounter European-style options on the Mexican Peso–US Dollar exchange rate. The non-parametric method was the superior one for out-of-sample evaluations. The implied mean, median and mode were, in general, statistically different between the competing approaches. It is recommended to apply the VFT instead of the MXL given that the former has superior accuracy and it can be estimated when there is a relatively short crosssection of option exercise price range. The results have implications for financial investors and policy makers given that they could use the information content in options to analyze market’s perceptions about the future expected variability of the financial asset under study.

Keywords: currency option implied volatility; exchange rate; parametric methods; non-parametric methods; risk-neutral densities (search for similar items in EconPapers)
JEL-codes: C14 C52 F31 G13 (search for similar items in EconPapers)
Date: 2008
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Citations: View citations in EconPapers (1)

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