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Reading the Smile: The Message Conveyed by Methods Which Infer Risk Neutral

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Author Info
Jondeau, E.
Rockinger, M.
Abstract

In this study we compare the quality and information content of risk neutral densities obtained by various methods. We consider a non-parametric method based on a mixture of log-normal densities, the semi-parametric ones based on an Hermite approximation of Madan and Milne, or based on an Edgeworth expansion of Jarrow and Rudd, the parametric approach of Malz which assumes a jump-diffusion for the underlying process, and eventually Heston's approach assuming a stochastic volatility model. We apply those models on FRF/DEM exchange rate options for two dates, for various maturities. Models differ when important news hit the market (here the 1997 snap elections). The non-parametric model provides a good fit to options prices but is unable under critical circumstances to provide as much information about market participants expectations than Malz's jump-diffusion model..

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Publisher Info
Paper provided by Banque de France in its series Documents de Travail with number 47.

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Length: 27 pages
Date of creation: 1998
Date of revision:
Handle: RePEc:bfr:banfra:47

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Related research
Keywords: Risk neutral density ; Option pricing ; Exchange rate option.;

Find related papers by JEL classification:
C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation and Testing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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    Other versions:
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