Working Paper

Estimation of risk-neutral and statistical densities by Hermite polynomial approximation: with an application to Eurodollar futures options

Abstract: This paper expands and tests the approach of Madan and Milne (1994) for pricing contingent claims as elements of a separable Hilbert space. We specialize the Hilbert space basis to the family of Hermite polynomials and use the model to price options on Eurodollar futures. Restrictions on the prices of Hermite polynomial risk for contingent claims with different times to maturity are derived. These restrictions are rejected by our empirical tests of a four-parameter model. The unrestricted results indicate skewness and excess kurtosis in the implied risk-neutral density. These characteristics of the density are also mirrored in the statistical density estimated from a time series on LIBOR. The out-of-sample performance of the four-parameter model is consistently better than that of a two-parameter version of the model.

Keywords: Euro-dollar market; Financial markets; Futures;

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Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 1996

Number: 96-5