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Parametric vs. non-parametric methods for estimating option implied risk-neutral densities: the case of the exchange rate Mexican peso – US dollar

Author

Listed:
  • Guillermo Benavides Perales
  • Israel Felipe Mora Cuevas

Abstract

This research paper presents statistical comparisons between two methods that are commonly used to estimate option implied Risk-Neutral Densities (RND). These are: 1) mixture of lognormals (MXL); and, 2) volatility function technique (VFT). The former is a parametric method whilst the latter is a non-parametric approach. The RNDs are extracted from over-thecounter European-style options on the Mexican Peso–US Dollar exchange rate. The non-parametric method was the superior one for out-of-sample evaluations. The implied mean, median and mode were, in general, statistically different between the competing approaches. It is recommended to apply the VFT instead of the MXL given that the former has superior accuracy and it can be estimated when there is a relatively short crosssection of option exercise price range. The results have implications for financial investors and policy makers given that they could use the information content in options to analyze market’s perceptions about the future expected variability of the financial asset under study. Clasificación JEL: C14, C52, F31, G13.

Suggested Citation

  • Guillermo Benavides Perales & Israel Felipe Mora Cuevas, 2008. "Parametric vs. non-parametric methods for estimating option implied risk-neutral densities: the case of the exchange rate Mexican peso – US dollar," Ensayos Revista de Economía, Universidad Autónoma de Nuevo León, vol. 27(1), pages 33-52, May.
    • Handle: RePEc:ere:journl:v:27:y:2008:i:1:id:104
    DOI: 10.29105/ensayos27.1-2
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    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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