Estimating the Implied Risk‐Neutral Density for the US Market Portfolio*

1 March 2010

book chapter
Published by Oxford University Press (OUP)

p. 323-353
https://doi.org/10.1093/acprof:oso/9780199549498.003.0015

Abstract

This chapter presents a new methodology for extracting complete well-behaved risk-neutral density (RND) functions from options market prices, and illustrates the potential of this tool for understanding how expectations and risk preferences are incorporated into prices in the US stock market. It reviews a variety of techniques for obtaining smooth densities from a set of observed options prices and selects one that offers good performance. This procedure is then modified to incorporate the market's bid-ask spread into the estimation. The chapter shows how the tails of the RND obtained from the options market may be extended and completed by appending tails from a generalized extreme value (GEV) distribution. The procedure is employed in order to estimate RNDs for the S&P 500 stock index from 1996-2008, and develops several interesting results.

Keywords

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