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Retrieving risk neutral densities from European option prices based on the principle of maximum entropy

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  • Rompolis, Leonidas S.

Abstract

This paper suggests a new method of implementing the principle of maximum entropy to retrieve the risk neutral density of future stock, or any other asset, returns from European call and put prices. The method maximizes the entropy measure subject to risk neutral moment constraints in place of option prices used by previous studies. These moments can be retrieved from market option prices at each point of time, in a first step. Compared to other existing methods of retrieving the risk neutral density based on the principle of maximum entropy, the benefits of the method that the paper suggests is the use of all the available information provided by the market more efficiently. To evaluate the performance of the suggested method, the paper compares it to other risk neutral density estimation techniques by conducting a simulation study and carrying out some crucial empirical exercises.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 17 (2010)
Issue (Month): 5 (December)
Pages: 918-937

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Handle: RePEc:eee:empfin:v:17:y:2010:i:5:p:918-937

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Web page: http://www.elsevier.com/locate/jempfin

Related research

Keywords: Maximum entropy Risk neutral density Risk neutral moments;

References

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Cited by:
  1. Fabozzi, Frank J. & Leccadito, Arturo & Tunaru, Radu S., 2014. "Extracting market information from equity options with exponential Lévy processes," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 125-141.
  2. Chalamandaris, Georgios & Rompolis, Leonidas S., 2012. "Exploring the role of the realized return distribution in the formation of the implied volatility smile," Journal of Banking & Finance, Elsevier, vol. 36(4), pages 1028-1044.

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