Implied Probability Distribution in Financial Options

Luis Ceballos

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: The objective of this work is to learn about the information contained in local market financial options regarding the peso-dollar parity. The goal is to test whether this is a relevant source that should be considered by the financial agents when forming expectations regarding the future path of underlying assets. The main methodologies for estimating the probability distribution function derived from option prices are reviewed. The present article relies on the methodology developed by Malz (1997) which, in contrast with others, makes no assumptions on the underlying asset and requires very few market quotes. The main results of this research are twofold. First, the implicit volatility in options does not perform better than alternative methods, and a significant bias and inefficiency component is found. Second, the interval forecasts derived from the probability distributions show that only the three-month-ahead forecast seems to be optimal in the sense of lack of both forecasting error lag dependence and dependence on volatility, while one- and six-month-ahead forecasts do exhibit these dependencies.

Date: 2010-10
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Persistent link: https://EconPapers.repec.org/RePEc:chb:bcchwp:596

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