Estimating option implied risk-neutral densities using spline and hypergeometric functions
Version of Record online: 23 APR 2007
The Econometrics Journal
Volume 10, Issue 2, pages 216–244, July 2007
How to Cite
Bu, R. and Hadri, K. (2007), Estimating option implied risk-neutral densities using spline and hypergeometric functions. The Econometrics Journal, 10: 216–244. doi: 10.1111/j.1368-423X.2007.00206.x
- Issue online: 23 APR 2007
- Version of Record online: 23 APR 2007
- First version received: January 2006; final version accepted: January 2007.
- Risk-neutral density;
- Natural spline;
- Hypergeometric functions;
- Root mean integrated squared error
Summary We examine the ability of two recent methods – the smoothed implied volatility smile method (SML) and the density functionals based on confluent hypergeometric functions (DFCH) – for estimating implied risk-neutral densities (RNDs) from European-style options. Two complementary Monte Carlo experiments are conducted and the performance of the two RND estimators is evaluated by the root mean integrated squared error (RMISE) criterion. Results from both experiments show that the DFCH method outperforms the SML method for the overall quality of the estimated RNDs concerning both accuracy and stability. An application of the two methods to the OTC currency options market is also presented.