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Implied Probability Distribution in Financial Options

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  • Luis Ceballos

Abstract

The objective of this work is to learn about the information contained in local market financial options regarding the peso-dollar parity. The goal is to test whether this is a relevant source that should be considered by the financial agents when forming expectations regarding the future path of underlying assets. The main methodologies for estimating the probability distribution function derived from option prices are reviewed. The present article relies on the methodology developed by Malz (1997) which, in contrast with others, makes no assumptions on the underlying asset and requires very few market quotes. The main results of this research are twofold. First, the implicit volatility in options does not perform better than alternative methods, and a significant bias and inefficiency component is found. Second, the interval forecasts derived from the probability distributions show that only the three-month-ahead forecast seems to be optimal in the sense of lack of both forecasting error lag dependence and dependence on volatility, while one- and six-month-ahead forecasts do exhibit these dependencies.

Suggested Citation

  • Luis Ceballos, 2010. "Implied Probability Distribution in Financial Options," Working Papers Central Bank of Chile 596, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:596
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_596.pdf
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    References listed on IDEAS

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    1. Jondeau, Eric & Rockinger, Michael, 2000. "Reading the smile: the message conveyed by methods which infer risk neutral densities," Journal of International Money and Finance, Elsevier, vol. 19(6), pages 885-915, December.
    2. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
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