The information content of risk-neutral densities: tests based on Hungarian currency option-implied densities

Csaba Csávás

The European Journal of Finance, 2010, vol. 16, issue 7, 657-676

Abstract: In this paper we test the information content of risk-neutral density functions estimated by the method of Malz [1997. Estimating the probability distribution of the future exchange rate from options prices. Journal of Derivatives 5, no. 2: 18-36]. The main question is whether risk-neutral densities coincide with the subjective densities. We find that the forecasting ability of 1-month EUR/HUF risk-neutral densities can be rejected for the period 2003-2007. Higher moments are responsible for the poor forecasting ability. Our interpretation is that the standard deviation, the skewness and the kurtosis of the risk-neutral densities are significantly above the respective central moments of subjective densities. We also find that delta-hedged gains on purchased options are negative, and can be considered high compared with the transaction costs of delta hedging.

Keywords: currency option; implied risk-neutral density function; density forecasting; delta-hedged gains; GMM (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1080/1351847X.2010.481451

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