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Comparison of methods to estimate option implied risk-neutral densities

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  • Wan-Ni Lai

Abstract

This paper is a comparison study of non-parametric techniques used to estimate risk-neutral densities from option prices. Cross-sectional option prices are first generated using Monte Carlo simulation. Using these simulated options data, risk-neutral densities of the underlying asset are estimated using three different non-parametric methods. The performances of these non-parametric estimation methods are then evaluated by comparing the estimated densities with the theoretical density. Unlike previous comparison studies that use traded options data without knowing the true risk-neutral densities, this study uses simulated option data with known data-generating processes and their corresponding risk-neutral densities, hence giving a real evaluation of the non-parametric estimation methods. This study finds that the kernel regression method yields the best performance, followed by the spline interpolation method and the neural network models.

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  • Wan-Ni Lai, 2014. "Comparison of methods to estimate option implied risk-neutral densities," Quantitative Finance, Taylor & Francis Journals, vol. 14(10), pages 1839-1855, October.
    • Handle: RePEc:taf:quantf:v:14:y:2014:i:10:p:1839-1855
    DOI: 10.1080/14697688.2011.606823
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    Cited by:

    1. Johannes Ruf & Weiguan Wang, 2019. "Neural networks for option pricing and hedging: a literature review," Papers 1911.05620, arXiv.org, revised May 2020.
    2. 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).
    3. 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.
    4. 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.

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