Recovering Probabilistic Information from Options Prices and the Underlying
Rutgers University, Department of Economics
February 10, 2008
This paper examines a variety of methods for extracting implied probability distributions from option prices and the underlying. The paper first explores non-parametric procedures for reconstructing densities directly from options market data. I then consider local volatility functions, both through implied volatility trees and volatility interpolation. I then turn to alternative specifications of the stochastic process for the underlying. I estimate a mixture of log normals model, apply it to exchange rate data, and illustrate how to conduct forecast comparisons. I finally turn to the estimation of jump risk by extracting bipower variation.
Number of Pages in PDF File: 29
Keywords: options, implied probability densities, volatility smile, jump risk, bipower variation
JEL Classification: G12, G14, F31working papers series
Date posted: March 25, 2007
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