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Testing the stability of implied probability density functions

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  • Robert R Bliss
  • Nikolaos Panigirtzoglou
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    Abstract

    Implied probability density functions (PDFs) estimated from cross-sections of observed option prices are gaining increasing attention amongst academics and practitioners. To date, however, little attention has been paid to the robustness of these estimates or to the confidence that users can place in the summary statistics (for example the skewness or the 99th percentile) derived from fitted PDFs. This paper begins to address these questions by examining the absolute and relative robustness of two of the most common methods for estimating implied PDFs - the double-lognormal approximating function and the smoothed implied volatility smile methods. The changes resulting from randomly perturbing quoted prices by no more than a half tick provide a lower bound on the confidence intervals of the summary statistics derived from the estimated PDFs. Tests are conducted using options contracts tied to short sterling futures and the FTSE 100 index - both trading on the London International Financial Futures and Options Exchange. The tests show that the smoothed implied volatility smile method dominates the double-lognormal as a technique for estimating implied PDFs when average goodness-of-fits for both methods are comparable.

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    Bibliographic Info

    Paper provided by Bank of England in its series Bank of England working papers with number 114.

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    Date of creation: May 2000
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    Handle: RePEc:boe:boeewp:114

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    1. repec:fth:baesse:9816 is not listed on IDEAS
    2. Shiratsuka, Shigenori, 2001. "Information Content of Implied Probability Distributions: Empirical Studies of Japanese Stock Price Index Options," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(3), pages 143-170, November.
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    Cited by:
    1. Aron Gereben, 2002. "Extracting market expectations from option prices: an application to over-the-counter New Zealand dollar options," Reserve Bank of New Zealand Discussion Paper Series DP2002/04, Reserve Bank of New Zealand.
    2. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB 38, ULB -- Universite Libre de Bruxelles.
    3. Martin Cincibuch, 2002. "Distributions Implied by Exchange Traded Options: A Ghost’s Smile?," CERGE-EI Working Papers wp200, The Center for Economic Research and Graduate Education - Economic Institute, Prague.

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