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Recovering Risk-Neutral Probability Density Functions from Options Prices using Cubic Splines

Ana M. Monteiro (amonteiro***at***fe.uc.pt)
Reha H. Tütüncü (reha***at***cmu.edu)
Luís N. Vicente (lnv***at***mat.uc.pt)

Abstract: We present a new approach to estimate the risk-neutral probability density function (pdf) of the future prices of an underlying asset from the prices of options written on the asset. The estimation is carried out in the space of cubic spline functions, yielding appropriate smoothness. The resulting optimization problem, used to invert the data and determine the corresponding density function, is a convex quadratic or semidefinite programming problem, depending on the formulation. Both of these problems can be efficiently solved by numerical optimization software. In the quadratic programming formulation the positivity of the risk-neutral pdf is heuristically handled by posing linear inequality constraints at the spline nodes. In the other approach, this property of the risk-neutral pdf is rigorously ensured by using a semidefinite programming characterization of nonnegativity for polynomial functions. We tested our approach using data simulated from Black-Scholes option prices and using market data for options on the S&P 500 Index. The numerical results we present show the effectiveness of our methodology for estimating the risk-neutral probability density function.

Keywords: option pricing, risk-neutral density estimation, cubic splines, quadratic programming, semidefinite programming

Category 1: Applications -- OR and Management Sciences (Finance and Economics )

Category 2: Linear, Cone and Semidefinite Programming (Semi-definite Programming )

Category 3: Nonlinear Optimization (Quadratic Programming )

Citation: Preprint 04-22 Department of Mathematics, University of Coimbra, Portugal July 2004

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Entry Submitted: 07/22/2004
Entry Accepted: 07/22/2004
Entry Last Modified: 07/22/2004

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