Estimating probability distributions of future asset prices: empirical transformations from option-implied risk-neutral to real-world density functions

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 21 June 2012

Working Paper No. 455
By Rupert de Vincent-Humphreys and Joseph Noss

The prices of derivatives contracts can be used to estimate ‘risk-neutral’ probability density functions that give an indication of the weight investors place on different future prices of their underlying assets, were they risk-neutral. In the likely case that investors are risk-averse, this leads to differences between the risk-neutral probability density and the actual distribution of prices. But if this difference displays a systematic pattern over time, it may be exploited to transform the risk-neutral density into a ‘real-world’ density that better reflect agents’ actual expectations. This work offers a methodology for performing this transformation. The resulting real-world densities may better represent market participants’ views of future prices, and so offer an enhanced means of quantifying the uncertainty around financial variables. Comparison with their risk-neutral equivalents may also reveal new and useful information as to how attitudes towards risk are affecting pricing.

PDF Estimating probability distributions of future asset prices: empirical transformations from option-implied risk-neutral to real-world density functions 

Other papers

Was this page useful?
Add your details...