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By William L. Mason
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Extra resources for Rubik's Revenge: The Simplest Solution
Sample text
2004, The Research Foundation of AIMR™ Option-Implied Risk-Neutral Distributions and Risk Aversion In terms of the statistics of risk-neutral distributions, the conclusion is that we have not made much progress. Only when we make rather restrictive assumptions about the error structure do we obtain any encouraging results. Once we use bootstrapped errors, our confidence is much smaller. As a result, we need to be cautious in interpreting risk-neutral distributions and should refrain from reading them too literally.
The reason is that there could be stochastic jumps, stochastic interest rates, or stochastic volatility—any of which will give rise to multiple processes consistent with observed prices. This problem is related to the problem of market incompleteness: If we encounter too many possible states and we have too few securities and too few trading opportunities, several risk-neutral stochastic processes are feasible that will price the observed securities correctly. Only if we are willing to limit ourselves to single-factor diffusion processes will we obtain a unique stochastic process.
A few final notes on implementation details may be helpful. The approach I have presented nests the Black–Scholes method, with its lognormal riskneutral distribution, as a limiting case when trade-off parameter λ goes to zero. The higher one sets λ, the better the fit of the option prices. 2 percent of the observed value. This choice assures, normally, that all risk-neutral probability distributions will be nonnegative and thus arbitrage free. Only a few options will be priced outside their empirical bid–ask spreads, and those tend to be options with extreme moneyness.