Journal of Financial and Quantitative Analysis

Research Article

Recovering Risk Neutral Densities from Option Prices: A New Approach

Leonidas S. Rompolis* and Elias Tzavalis*

Abstract

In this paper we present a new method of approximating the risk neutral density (RND) from option prices based on the C-type Gram-Charlier series expansion (GCSE) of a probability density function. The exponential form of this type of GCSE guarantees that it will always give positive values of the risk neutral probabilities, and it can allow for stronger deviations from normality, which are two drawbacks of the A-type GCSE used in practice. To evaluate the performance of the suggested expansion of the RND, the paper presents simulation and empirical evidence.

Footnotes

* Rompolis, rompolis@ucy.ac.cy, Department of Public and Business Administration, University of Cyprus, 9-11 Larnakos str, Nicosia, Cyprus; and Tzavalis, tzavalis@aueb.gr, Department of Economics, Athens University of Economics and Business, 76 Patission str, Athens 104 34, Greece. The authors thank Gurdip Bakshi (associate editor and referee) and Paul Malatesta (the editor) for their comments and suggestions on an earlier version of the paper. Rompolis acknowledges financial support from the Iraklitos Fellowships of Research of the Athens University of Economics and Business.

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