Reading the smile: the message conveyed by methods which infer risk neutral densities
Eric Jondeau and Michael Rockinger*
Journal of International Money and Finance, 2000, 19(6), 885-915.
Abstract
In this study we compare the quality and information content of risk neutral densities obtained by various methods. We consider a non-parametric method based on a mixture of log–normal densities, the semi-parametric ones based on an Hermite approximation or based on an Edgeworth expansion, the parametric approach of Malz which assumes a jump-diffusion for the underlying process, and Heston's approach assuming a stochastic volatility model. We apply those models on FF/DM exchange rate options for two dates. Models differ when important news hits the market (here anticipated elections). The non-parametric model provides a good fit to options prices but is unable to provide as much information about market participants expectations than the jump-diffusion model.
Keywords: Risk–neutral density; Exchange rate options; Option pricing
JEL classification: C52; G14; G15; F31; F33.
* HEC Lausanne