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Implied Risk Neutral Densities From Option Prices: Hypergeometric, Spline, Lognormal, and Edgeworth Functions

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  • André Santos
  • João Guerra

Abstract

This work examines the performance of four different methods to estimate the “true” Risk‐Neutral Density functions (RNDs) using European options. These methods are the Mixture of Lognormal distributions (MLN), the Smoothed Implied Volatility Smile (SML), the Density Functional Based on the Confluent Hypergeometric function (DFCH), and the Edgeworth expansions (EE). The “true” RND is unknown, so it was generated using the stochastic Heston model and considering parameters that reflect the characteristics of the options market for the US dollar and Brazilian real exchange rate (USD/BRL). We find that the DFCH and MLN have the best performance in capturing the “true” RNDs. © 2014 Wiley Periodicals, Inc. Jrl Fut Mark 35:655–678, 2015

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  • André Santos & João Guerra, 2015. "Implied Risk Neutral Densities From Option Prices: Hypergeometric, Spline, Lognormal, and Edgeworth Functions," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 35(7), pages 655-678, July.
    • Handle: RePEc:wly:jfutmk:v:35:y:2015:i:7:p:655-678
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    Cited by:

    1. Chen, Ren-Raw & Hsieh, Pei-lin & Huang, Jeffrey, 2018. "Crash risk and risk neutral densities," Journal of Empirical Finance, Elsevier, vol. 47(C), pages 162-189.
    2. Shan Lu, 2019. "Monte Carlo analysis of methods for extracting risk‐neutral densities with affine jump diffusions," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 39(12), pages 1587-1612, December.
    3. Michael C. Fu & Bingqing Li & Guozhen Li & Rongwen Wu, 2017. "Option Pricing for a Jump-Diffusion Model with General Discrete Jump-Size Distributions," Management Science, INFORMS, vol. 63(11), pages 3961-3977, November.
    4. Atilgan, Yigit & Demirtas, K. Ozgur & Simsek, Koray D., 2016. "Derivative markets in emerging economies: A survey," International Review of Economics & Finance, Elsevier, vol. 42(C), pages 88-102.

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