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Option-implied probability distributions: How reliable? How jagged?

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  • Taboga, Marco

Abstract

Estimates of option-implied probability distributions are routinely used in central banks, as well as in other institutions, but their reliability is often difficult to assess. To address this issue, we propose a semi-nonparametric model that allows to compute exact credible intervals around estimated distributions. By analyzing a panel of S&P 500 options, we find that the estimates of the distributions are quite precise. We also provide evidence that the multi-modality often found in option-implied distributions could be an artifact due to over-fitting, and that models with uni-modality constraints have high posterior odds.

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  • Taboga, Marco, 2016. "Option-implied probability distributions: How reliable? How jagged?," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 453-469.
    • Handle: RePEc:eee:reveco:v:45:y:2016:i:c:p:453-469
    DOI: 10.1016/j.iref.2016.07.013
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    Cited by:

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    2. Guidolin, Massimo & Wang, Kai, 2023. "The empirical performance of option implied volatility surface-driven optimal portfolios," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 618(C).
    3. Lina M. Cortés & Javier Perote & Andrés Mora-Valencia, 2017. "Implicit probability distribution for WTI options: The Black Scholes vs. the semi-nonparametric approach," Documentos de Trabajo de Valor Público 15923, Universidad EAFIT.
    4. Michele Leonardo Bianchi & Gian Luca Tassinari, 2018. "Forward-looking portfolio selection with multivariate non-Gaussian models and the Esscher transform," Papers 1805.05584, arXiv.org, revised May 2018.
    5. Cortés, Lina M. & Mora-Valencia, Andrés & Perote, Javier, 2020. "Retrieving the implicit risk neutral density of WTI options with a semi-nonparametric approach," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).
    6. Sara Cecchetti & Adriana Grasso & Marcello Pericoli, 2022. "An analysis of objective inflation expectations and inflation risk premia," Temi di discussione (Economic working papers) 1380, Bank of Italy, Economic Research and International Relations Area.
    7. Stefano Neri & Stefano Siviero, 2019. "The non-standard monetary policy measures of the ECB: motivations, effectiveness and risks," Questioni di Economia e Finanza (Occasional Papers) 486, Bank of Italy, Economic Research and International Relations Area.

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    More about this item

    Keywords

    Implied state prices; Implied risk-neutral distributions; State price estimation; Option-implied distributions;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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