A New Framework to Estimate the Risk-Neutral Probability Density Functions Embedded in Options Prices

Kevin Cheng

No 2010/181, IMF Working Papers from International Monetary Fund

Abstract: Building on the widely-used double-lognormal approach by Bahra (1997), this paper presents a multi-lognormal approach with restrictions to extract risk-neutral probability density functions (RNPs) for various asset classes. The contributions are twofold: first, on the technical side, the paper proposes useful transformation/restrictions to Bahra’s original formulation for achieving economically sensible outcomes. In addition, the paper compares the statistical properties of the estimated RNPs among major asset classes, including commodities, the S&P 500, the dollar/euro exchange rate, and the US 10-year Treasury Note. Finally, a Monte Carlo study suggests that the multi-lognormal approach outperforms the double-lognormal approach.

Keywords: WP (search for similar items in EconPapers)
Pages: 31
Date: 2010-08-01
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Citations: View citations in EconPapers (7)

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