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Interpreting the volatility smile: an examination of the information content of option prices

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  • Steven A. Weinberg

Abstract

This paper evaluates how useful the information contained in options prices is for predicting future price movements of the underlying assets. We develop an improved semiparametric methodology for estimating risk-neutral probability density functions (PDFs), which allows for skewness and intertemporal variation in higher moments. We use this technique to estimate a daily time series of risk-neutral PDFs spanning the late 1980's through 1999, for S&P 500 futures, U.S. dollar/Japanese yen futures and U.S. dollar/deutsche mark futures, using options on these futures. For the foreign exchange futures, we find little discernable additional information contained in the estimated PDFs beyond the information derived from the Black-Scholes model, a fully parametric specification. For S&P 500 futures, we find that the risk-neutral distribution implied by the volatility smile better fits the realized returns than the Black-Scholes model, although this better overall fit is not exhibited in the second and third moments.

Suggested Citation

  • Steven A. Weinberg, 2001. "Interpreting the volatility smile: an examination of the information content of option prices," International Finance Discussion Papers 706, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:706
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    References listed on IDEAS

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    1. Corrado, Charles J & Su, Tie, 1996. "Skewness and Kurtosis in S&P 500 Index Returns Implied by Option Prices," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 19(2), pages 175-192, Summer.
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    1. repec:eee:eneeco:v:64:y:2017:i:c:p:440-457 is not listed on IDEAS
    2. Datta, Deepa Dhume & Londono, Juan M. & Ross, Landon J, 2014. "Generating Options-Implied Probability Densities to Understand Oil Market Events," International Finance Discussion Papers 1122, Board of Governors of the Federal Reserve System (U.S.).
    3. Christoffersen, Peter & Jacobs, Kris & Chang, Bo Young, 2013. "Forecasting with Option-Implied Information," Handbook of Economic Forecasting, Elsevier.
    4. Marian Micu, 2005. "Extracting expectations from currency option prices: a comparison of methods," Computing in Economics and Finance 2005 226, Society for Computational Economics.
    5. Carol Alexander & Alexander Rubinov & Markus Kalepky & Stamatis Leontsinis, 2012. "Regime‐dependent smile‐adjusted delta hedging," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(3), pages 203-229, March.
    6. Xiaoquan Liu, 2007. "Returns to trading portfolios of FTSE 100 index options," Applied Financial Economics, Taylor & Francis Journals, vol. 17(15), pages 1211-1225.
    7. Francisco Alonso & Roberto Blanco & Gonzalo Rubio, 2005. "Testing the forecasting performace of IBEX 35 option implied risk neutral densities," Working Papers 0504, Banco de España;Working Papers Homepage.

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    Keywords

    Risk management ; Asset-liability management;

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