IDEAS home Printed from https://ideas.repec.org/p/pra/mprapa/11634.html
   My bibliography  Save this paper

Option Implied Risk-Neutral Distributions and Implied Binomial Trees: A Literature Review

Author

Listed:
  • Jackwerth, Jens Carsten

Abstract

In this selective literature review, we start by observing that in efficient markets, there is information incorporated in option prices that might help us to design option pricing models. To this end, we review the numerous methods of recovering risk-neutral probability distributions from option prices at one particular time to expiration and their applications. Next, we move beyond one time to expiration to the construction of implied binomial trees, which model the stochastic process of the underlying asset. Finally, we describe extensions of implied binomial trees, and other non-parametric methods.

Suggested Citation

  • Jackwerth, Jens Carsten, 1999. "Option Implied Risk-Neutral Distributions and Implied Binomial Trees: A Literature Review," MPRA Paper 11634, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:11634
    as

    Download full text from publisher

    File URL: https://mpra.ub.uni-muenchen.de/11634/2/MPRA_paper_11634.pdf
    File Function: original version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Bates, David S, 1991. "The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 1009-1044, July.
    2. Buchen, Peter W. & Kelly, Michael, 1996. "The Maximum Entropy Distribution of an Asset Inferred from Option Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(1), pages 143-159, March.
    3. Karim Abadir & Michael Rockinger, "undated". "Density-Embedding Functions," Discussion Papers 97/16, Department of Economics, University of York.
    4. Campa, Jose M. & Chang, P. H. Kevin & Reider, Robert L., 1998. "Implied exchange rate distributions: evidence from OTC option markets1," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 117-160, February.
    5. Bookstaber, Richard M & McDonald, James B, 1987. "A General Distribution for Describing Security Price Returns," The Journal of Business, University of Chicago Press, vol. 60(3), pages 401-424, July.
    6. Bhupinder Bahra, 1997. "Implied risk-neutral probability density functions from option prices: theory and application," Bank of England working papers 66, Bank of England.
    7. Campa, Jose Manuel & Chang, P H Kevin, 1996. "Arbitrage-Based Tests of Target-Zone Credibility: Evidence from ERM Cross-Rate Options," American Economic Review, American Economic Association, vol. 86(4), pages 726-740, September.
    8. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-651, October.
    9. Brenner, Menachem & Eom, Young Ho & Landskroner, Yoram, 1996. "Implied foreign exchange rates using options prices," International Review of Financial Analysis, Elsevier, vol. 5(3), pages 171-183.
    10. 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 637-654, May-June.
    11. Menachem Brenner & Young Ho Eom, 1997. "No-Arbitrage Option Pricing: New Evidence on the Validity of the Martingale Property," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-009, New York University, Leonard N. Stern School of Business-.
    12. Banz, Rolf W & Miller, Merton H, 1978. "Prices for State-contingent Claims: Some Estimates and Applications," The Journal of Business, University of Chicago Press, vol. 51(4), pages 653-672, October.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Christoffersen, Peter & Jacobs, Kris & Chang, Bo Young, 2013. "Forecasting with Option-Implied Information," Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.), Handbook of Economic Forecasting, edition 1, volume 2, chapter 0, pages 581-656, Elsevier.
    2. Bondarenko, Oleg, 2003. "Estimation of risk-neutral densities using positive convolution approximation," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 85-112.
    3. René Garcia & Eric Ghysels & Eric Renault, 2004. "The Econometrics of Option Pricing," CIRANO Working Papers 2004s-04, CIRANO.
    4. Jurczenko, Emmanuel & Maillet, Bertrand & Negrea, Bogdan, 2002. "Revisited multi-moment approximate option pricing models: a general comparison (Part 1)," LSE Research Online Documents on Economics 24950, London School of Economics and Political Science, LSE Library.
    5. Coutant, Sophie & Jondeau, Eric & Rockinger, Michael, 2001. "Reading PIBOR futures options smiles: The 1997 snap election," Journal of Banking & Finance, Elsevier, vol. 25(11), pages 1957-1987, November.
    6. Bogdan Negrea & Bertrand Maillet & Emmanuel Jurczenko, 2002. "Revisited Multi-moment Approximate Option," FMG Discussion Papers dp430, Financial Markets Group.
    7. Arindam Kundu & Sumit Kumar & Nutan Kumar Tomar, 2019. "Option Implied Risk-Neutral Density Estimation: A Robust and Flexible Method," Computational Economics, Springer;Society for Computational Economics, vol. 54(2), pages 705-728, August.
    8. Dupont, Dominique Y., 2001. "Extracting Risk-Neutral Probability Distributions from Option Prices Using Trading Volume as a Filter," Economics Series 104, Institute for Advanced Studies.
    9. Monteiro, Ana Margarida & Tutuncu, Reha H. & Vicente, Luis N., 2008. "Recovering risk-neutral probability density functions from options prices using cubic splines and ensuring nonnegativity," European Journal of Operational Research, Elsevier, vol. 187(2), pages 525-542, June.
    10. Josip Arneric & Zdravka Aljinovic & Tea Poklepovic, 2015. "Extraction of market expectations from risk-neutral density," Zbornik radova Ekonomskog fakulteta u Rijeci/Proceedings of Rijeka Faculty of Economics, University of Rijeka, Faculty of Economics and Business, vol. 33(2), pages 235-256.
    11. Rzepkowski, Bronka, 2003. "The devaluation expectations in Hong Kong and their determinants," Journal of the Japanese and International Economies, Elsevier, vol. 17(2), pages 174-191, June.
    12. Salazar Celis, Oliver & Liang, Lingzhi & Lemmens, Damiaan & Tempère, Jacques & Cuyt, Annie, 2015. "Determining and benchmarking risk neutral distributions implied from option prices," Applied Mathematics and Computation, Elsevier, vol. 258(C), pages 372-387.
    13. repec:wyi:journl:002108 is not listed on IDEAS
    14. Ruijun Bu & Kaddour Hadri, 2005. "Estimating the Risk Neutral Probability Density Functions Natural Spline versus Hypergeometric Approach Using European Style Options," Working Papers 200510, University of Liverpool, Department of Economics.
    15. Carvalho, Augusto & Guimaraes, Bernardo, 2018. "State-controlled companies and political risk: Evidence from the 2014 Brazilian election," Journal of Public Economics, Elsevier, vol. 159(C), pages 66-78.
    16. Nakamura, Hisashi & Shiratsuka, Shigenori, 1999. "Extracting Market Expectations from Option Prices: Case Studies in Japanese Option Markets," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 17(1), pages 1-43, May.
    17. Marie Briere, 2006. "Market Reactions to Central Bank Communication Policies :Reading Interest Rate Options Smiles," Working Papers CEB 38, ULB -- Universite Libre de Bruxelles.
    18. Martin Mandler, 2002. "Extracting Market Expectations from Option Prices: Two Case Studies in Market Perceptions of the ECB's Monetary Policy 1999/2000," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 138(II), pages 165-189, June.
    19. Abarca Gustavo & Rangel José Gonzalo & Benavides Guillermo, 2010. "Exchange Rate Market Expectations and Central Bank Policy: The case of the Mexican Peso-US Dollar from 2005-2009," Working Papers 2010-17, Banco de México.
    20. Sheri Markose & Amadeo Alentorn, 2005. "Option Pricing and the Implied Tail Index with the Generalized Extreme Value (GEV) Distribution," Computing in Economics and Finance 2005 397, Society for Computational Economics.
    21. Jean-Baptiste Monnier, 2013. "Technical report : Risk-neutral density recovery via spectral analysis," Papers 1302.2567, arXiv.org.

    More about this item

    Keywords

    Binomial Trees; Risk-Neutral;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:pra:mprapa:11634. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Joachim Winter (email available below). General contact details of provider: https://edirc.repec.org/data/vfmunde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.