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Inverse Learning of Latent Risk-Neutral Densities from Irregular Option Quotes

Author

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  • Lennon J. Shikhman
  • Michael Galarnyk
  • Aadi Dash
  • Nicholas A. Welsh

Abstract

Accurate option prices do not imply accurate recovery of the latent risk-neutral density. We study this distinction with two complementary benchmarks. A controlled benchmark exposes simulator-truth densities for latent evaluation, while a chronological NIFTY benchmark tests only held-out market prices. A two-component lognormal mixture has the lowest aggregate price, $L^1$, Wasserstein, and fixed-tail errors on the synthetic benchmark. Learned operators retain narrower strengths: DeepONet reduces 1% quantile and variance error by 39.0% and 34.6% relative to the mixture, and a quote transformer reduces $L^1$ by 16.4% on the structurally misspecified Merton family. A numerical conditioning analysis explains why these rankings can differ: after enforcing mass and forward constraints, 95 of 126 pricing directions are numerically null, and two densities separated by $L^1 = 0.061$ produce identical prices on the covered strikes. On 524 held-out NIFTY calls, validation-selected test-time adaptation reduces DeepONet RMSE by 28.3%, but per-expiry mixture and SVI fits remain much more accurate. The evidence supports target-dependent inductive bias, not a universal winner.

Suggested Citation

  • Lennon J. Shikhman & Michael Galarnyk & Aadi Dash & Nicholas A. Welsh, 2026. "Inverse Learning of Latent Risk-Neutral Densities from Irregular Option Quotes," Papers 2607.27188, arXiv.org.
  • Handle: RePEc:arx:papers:2607.27188
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