State Price Density Estimation with an Application to the Recovery Theorem

28 Pages Posted: 12 May 2018 Last revised: 5 Dec 2019

Date Written: April 29, 2018

Abstract

I introduce a model to estimate the risk-neutral density. Current estimation techniques use a single mathematical model to interpolate option prices on two option dimensions: strike price and time-to maturity (TTM). I propose to use B-splines with at-the-money knots for the strike price interpolation and a function that depends on the option expiration horizon for the TTM interpolation. The results of this “hybrid” methodology are significantly better than other risk-neutral density extrapolation methods applied to the Recovery Theorem.

Keywords: Risk Neutral Density, Recovery Theorem, Implied Probabilities, Contingent Pricing, Information and Market Efficiency

JEL Classification: G13, G14, G17

Suggested Citation

Sanford, Anthony, State Price Density Estimation with an Application to the Recovery Theorem (April 29, 2018). Available at SSRN: https://ssrn.com/abstract=3126428 or http://dx.doi.org/10.2139/ssrn.3126428

Anthony Sanford (Contact Author)

University of Maryland ( email )

4113AA Van Munching Hall
College Park, MD 20742
United States

HOME PAGE: http://www.terpconnect.umd.edu/~sanfoan/

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