Estimating probability distributions of future asset prices: empirical transformations from option-implied risk-neutral to real-world density functions

Rupert de Vincent-Humphreys () and Joseph Noss ()
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Rupert de Vincent-Humphreys: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Joseph Noss: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH

No 455, Bank of England working papers from Bank of England

Abstract: The prices of derivatives contracts can be used to estimate ‘risk-neutral’ probability density functions that give an indication of the weight investors place on different future prices of their underlying assets, were they risk-neutral. In the likely case that investors are risk-averse, this leads to differences between the risk-neutral probability density and the actual distribution of prices. But if this difference displays a systematic pattern over time, it may be exploited to transform the risk-neutral density into a ‘real-world’ density that better reflect agents’ actual expectations. This work offers a methodology for performing this transformation. The resulting real-world densities may better represent market participants’ views of future prices, and so offer an enhanced means of quantifying the uncertainty around financial variables. Comparison with their risk-neutral equivalents may also reveal new and useful information as to how attitudes towards risk are affecting pricing.

Keywords: Asset prices; derivatives; expectations; options; option-implied density; risk premia; probability density forecasting; probability measure (search for similar items in EconPapers)
JEL-codes: G10 G12 G13 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2012-06-21
New Economics Papers: this item is included in nep-for and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (20)

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