Report

Simple and reliable way to compute option-based risk-neutral distributions

Abstract: This paper describes a method for computing risk-neutral density functions based on the option-implied volatility smile. Its aim is to reduce complexity and provide cookbook-style guidance through the estimation process. The technique is robust and avoids violations of option no-arbitrage restrictions that can lead to negative probabilities and other implausible results. I give examples for equities, foreign exchange, and long-term interest rates.

Keywords: option pricing; risk-neutral distributions;

JEL Classification: G01; G13; G17; G18;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2014-06-01

Number: 677