Estimating probability distributions of future asset prices: empirical transformations from option-implied risk-neutral to real-world density functions
AbstractThe prices of derivatives contracts can be used to estimate ‘risk-neutral’ probability density functions that give an indication of the weight investors place on different future prices of their underlying assets, were they risk-neutral. In the likely case that investors are risk-averse, this leads to differences between the risk-neutral probability density and the actual distribution of prices. But if this difference displays a systematic pattern over time, it may be exploited to transform the risk-neutral density into a ‘real-world’ density that better reflect agents’ actual expectations. This work offers a methodology for performing this transformation. The resulting real-world densities may better represent market participants’ views of future prices, and so offer an enhanced means of quantifying the uncertainty around financial variables. Comparison with their risk-neutral equivalents may also reveal new and useful information as to how attitudes towards risk are affecting pricing.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 455.
Length: 39 pages
Date of creation: 21 Jun 2012
Date of revision:
Contact details of provider:
Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Phone: +44 (0)171 601 4030
Fax: +44 (0)171 601 5196
Web page: http://www.bankofengland.co.uk/
More information through EDIRC
Asset prices; derivatives; expectations; options; option-implied density; risk premia; probability density forecasting; probability measure;
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-07-08 (All new papers)
- NEP-FOR-2012-07-08 (Forecasting)
- NEP-UPT-2012-07-08 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Inkinen, Mika & Stringa, Marco & Voutsinou, Kyriaki, 2010. "Interpreting equity price movements since the start of the financial crisis," Bank of England Quarterly Bulletin, Bank of England, vol. 50(1), pages 24-33.
- Shackleton, Mark B. & Taylor, Stephen J. & Yu, Peng, 2010. "A multi-horizon comparison of density forecasts for the S&P 500 using index returns and option prices," Journal of Banking & Finance, Elsevier, vol. 34(11), pages 2678-2693, November.
- Liu, Xiaoquan & Shackleton, Mark B. & Taylor, Stephen J. & Xu, Xinzhong, 2007. "Closed-form transformations from risk-neutral to real-world distributions," Journal of Banking & Finance, Elsevier, vol. 31(5), pages 1501-1520, May.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Publications Team).
If references are entirely missing, you can add them using this form.