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Extracting Risk-Neutral Probability Distributions from Option Prices Using Trading Volume as a Filter

Author

Listed:
  • Dupont, Dominique Y.

    (EURANDOM - TUE, The Netherlands)

Abstract

This paper introduces a new technique to infer the risk-neutral probability distribution of an asset from the prices of options on this asset. The technique is based on using the trading volume of each option as a proxy of the informativeness of the option. Not requiring the implied probability distribution to recover exactly the market prices of the options allows us to weight each option by a function of its trading volume. As a result, we obtain implied probability distributions that are both smoother and should be more reflective of fundamentals.

Suggested Citation

  • 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.
  • Handle: RePEc:ihs:ihsesp:104
    as

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    File URL: http://www.ihs.ac.at/publications/eco/es-104.pdf
    File Function: First version, 2001
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    References listed on IDEAS

    as
    1. Soderlind, Paul & Svensson, Lars, 1997. "New techniques to extract market expectations from financial instruments," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 383-429, October.
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    7. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
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    Citations

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    Cited by:

    1. 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.
    2. Christoffersen, Peter & Jacobs, Kris & Chang, Bo Young, 2013. "Forecasting with Option-Implied Information," Handbook of Economic Forecasting, Elsevier.
    3. Healy, Jerome V. & Dixon, Maurice & Read, Brian J. & Cai, Fang Fang, 2007. "Non-parametric extraction of implied asset price distributions," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 382(1), pages 121-128.

    More about this item

    Keywords

    Implied risk-neutral probability distribution; Implied-tree method;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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