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Federal Reserve Bank of New York
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Simple and reliable way to compute option-based risk-neutral distributions
Allan M. Malz
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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Allan M. Malz, Simple and reliable way to compute option-based risk-neutral distributions, Federal Reserve Bank of New York, Staff Reports 677, 01 Jun 2014.
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Keywords: option pricing; risk-neutral distributions
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