Implied PDFs: Estimation, Testing and Applications in the Eurodollar Market
Bank of America - Bank of America Merrill Lynch; Athens University of Economics and Business; City University London - Cass Business School - Faculty of Finance; EDHEC Risk Institute
Cass Business School Research Paper
This paper develops a method for estimating implied PDFs for futures prices from American options. The restricting assumption of log-normally distributed returns is relaxed with the use of the more flexible distributional form of an Edgeworth Series Expansion (ESE) of a log-normal distribution. The method is applied to Eurodollar futures options market data and a plethora of tests is employed to explore its capacity. The proposed model is found to be able to estimate PDFs that can capture the general market sentiment and also incorporate isolated events causing a significant impact on the market. In addition to exploring the 'economic' sensibility of the recovered densities, their statistical properties are examined against the properties of PDFs estimated with the use of alternative methodologies. A superior behaviour is present in most of the cases addressed. Based on the proposed model, a new setting that allows to explicitly quantify the information content of option prices is also developed.
Number of Pages in PDF File: 41
JEL Classification: G10, G12, G13, G14
Date posted: July 21, 2004