Reading the Smile: The Message Conveyed by Methods Which Infer Risk Neutral Densities

E. Jondeau, M. ROCKINGER

Journal of International Money and Finance

December 2000, vol. 19, n°6, pp.885-915

Departments: Finance

Keywords: Risk–neutral density, Exchange rate options, Option pricing

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 mode