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.
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Provider: Federal Reserve Bank of New York
Part of Series: Staff Reports
Publication Date: 2014-06-01