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Distributions Implied by Exchange Traded Options: A Ghost’s Smile?

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Author Info
Martin Cincibuch

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Abstract

A new and easily applicable method for estimating risk neutral distributions (RND) implied by American futures options is proposed. It amounts to inverting the Barone-Adesi and Whaley method (1987) (BAW method) to get the BAW-implied volatility smile. Extensive empirical tests show that the BAW smile is equivalent to the volatility smile implied by corresponding European options. Therefore, the procedure leads to a legitimate RND estimation method. Further, the investigation of the currency options traded on the Chicago Mercantile Exchange and OTC markets in parallel provides us with insights on the structure and interaction of the two markets. Unequally distributed liquidity in the OTC market seems to lead to price distortions and an ensuing interesting `ghost- like' shape of the RND density implied by CME options. Finally, using the empirical results, we propose a parsimonious generalisation of the existing methods for estimating volatility smiles from OTC options. A single free parameter significantly improves the fit. Note:The revised version of this paper was published as: Cincibuch, M., 2004. Distributions Implied by American Currency Futures Options: A Ghosts' Smile ? Journal of Futures Markets, 2004, 24(2).

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Paper provided by The Center for Economic Research and Graduate Education - Economic Institute, Prague in its series CERGE-EI Working Papers with number wp200.

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Date of creation: Oct 2002
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Handle: RePEc:cer:papers:wp200

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  1. Whaley, Robert E, 1986. " Valuation of American Futures Options: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 41(1), pages 127-50, March. [Downloadable!] (restricted)
  2. Soderlind, Paul & Svensson, Lars, 1997. "New techniques to extract market expectations from financial instruments," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 383-429, October. [Downloadable!] (restricted)
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  3. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179. [Downloadable!] (restricted)
  4. Bruce D. Grundy, . "Option Prices and the Underlying Asset's Return Distribution (Reprint 012)," Rodney L. White Center for Financial Research Working Papers 11-91, Wharton School Rodney L. White Center for Financial Research.
  5. Jose M. Campa & P.H. Kevin Chang & Robert L. Reider, 1997. "Implied Exchange Rate Distributions: Evidence from OTC Option Markets," NBER Working Papers 6179, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Robert R Bliss & Nikolaos Panigirtzoglou, . "Testing the stability of implied probability density functions," Bank of England working papers 114, Bank of England. [Downloadable!]
  7. Jon Danielsson, 2000. "The Emperor has no Clothes: Limits to Risk Modelling," FMG Special Papers sp126, Financial Markets Group. [Downloadable!] (restricted)
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  8. Grundy, Bruce D, 1991. " Option Prices and the Underlying Asset's Return Distribution," Journal of Finance, American Finance Association, vol. 46(3), pages 1045-69, July. [Downloadable!] (restricted)
  9. Dong-Hyun Ahn & Jacob Boudoukh & Matthew Richardson & Robert F. Whitelaw, 1999. "Optimal Risk Management Using Options," Journal of Finance, American Finance Association, vol. 54(1), pages 359-375, 02. [Downloadable!] (restricted)
  10. Cox, John C. & Ingersoll, Jonathan Jr. & Ross, Stephen A., 1981. "The relation between forward prices and futures prices," Journal of Financial Economics, Elsevier, vol. 9(4), pages 321-346, December. [Downloadable!] (restricted)
  11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  12. Grundy, R.D., 1991. "Option Prices and the Underlying Asset's Return Distribution," Weiss Center Working Papers 11-91, Wharton School - Weiss Center for International Financial Research.
  13. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December. [Downloadable!] (restricted)
  14. Jorion, Philippe, 1995. " Predicting Volatility in the Foreign Exchange Market," Journal of Finance, American Finance Association, vol. 50(2), pages 507-28, June. [Downloadable!] (restricted)
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