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Inferring Risk-Averse Probability Distributions from Option Prices Using Implied Binomial Trees

In: Financial Econometrics Modeling: Derivatives Pricing, Hedge Funds and Term Structure Models

Author

Listed:
  • Tom Arnold
  • Timothy Falcon Crack
  • Adam Schwartz

Abstract

We generalize the Rubinstein (1994) risk-neutral implied binomial tree (R-IBT) model to a physical-world risk-averse implied binomial tree (RA-IBT) model. The R-IBT and RA-IBT trees are bound together via a relationship requiring a risk premium (or a risk-adjusted discount rate) on the underlying asset at any node. The RA-IBT provides a powerful numerical platform for many empirical financial option and real option applications; these include probabilistic inference, pricing, and utility theory applications.

Suggested Citation

  • Tom Arnold & Timothy Falcon Crack & Adam Schwartz, 2011. "Inferring Risk-Averse Probability Distributions from Option Prices Using Implied Binomial Trees," Palgrave Macmillan Books, in: Greg N. Gregoriou & Razvan Pascalau (ed.), Financial Econometrics Modeling: Derivatives Pricing, Hedge Funds and Term Structure Models, chapter 2, pages 35-52, Palgrave Macmillan.
    • Handle: RePEc:pal:palchp:978-0-230-29520-9_2
    DOI: 10.1057/9780230295209_2
    as

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