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The minimum local cross-entropy criterion for inferring risk-neutral price distributions from traded options prices

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  • David Edelman

Abstract

A quantity known as the Local Cross-Entropy (LCE) for a density is proposed, defined to be the local derivative of the Cross-Entropy between a density and a ’kernel-smoothed’ version of itself, with respect to bandwidth of the smoothing. This criterion is argued to be of the ’smoothness’ type and is also argued to be more sensible and ’natural’ than the frequently used ’Maximum Entropy’ criterion for many applications. When applied to price distributions in conjunction Options constraints the minimum LCE criterion is shown to produce estimates which share the best theoretical properties of the Maximum Entropy approach with the best practical properties of the estimators identified by Jackwerth and Rubinstein

Suggested Citation

  • David Edelman, 2004. "The minimum local cross-entropy criterion for inferring risk-neutral price distributions from traded options prices," Centre for Financial Markets Working Papers 10197/1127, Research Repository, University College Dublin.
    • Handle: RePEc:rru:cfmwps:10197/1127
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    File URL: http://hdl.handle.net/10197/1127
    File Function: First version, 2004
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