Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices
Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
Andrew W. Lo
Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)
Journal of Finance, Vol. 53, No. 2, April 1998
Implicit in the prices of traded financial assets are Arrow-Debreu prices or, with continuous states, the state-price density (SPD). We construct a nonparametric estimator for the SPD implicit in option prices and derive its asymptotic sampling theory. This estimator provides an arbitrage-free method of pricing new, complex, or illiquid securities while capturing those features of the data that are most relevant from an asset-pricing perspective, e.g.,negative skewness and excess kurtosis for asset returns, volatility "smiles" for option prices. We perform Monte Carlo experiments and extract the SPD from actual S&P 500 option prices.
JEL Classification: C14, G13Accepted Paper Series
Date posted: August 2, 1998
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