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Recovering Risk Neutral Densities from Option Prices: A New Approach

Published online by Cambridge University Press:  06 April 2009

Leonidas S. Rompolis  and
Elias Tzavalis
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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.

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Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 43 , Issue 4 , December 2008 , pp. 1037 - 1053
Copyright
Copyright © School of Business Administration, University of Washington 2008

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