Recovering risk-neutral probability density functions from options prices using cubic splines and ensuring nonnegativity

• Published in: European journal of operational research 2008-06, Vol.187 (2), p.525-542
• Main Authors: Monteiro, Ana Margarida, Tütüncü, Reha H., Vicente, Luís N.
• Format: Article
• Language: English
• Subjects: Applied sciences; Cubic splines; Estimating techniques; Exact sciences and technology; Heuristic; Operational research and scientific management; Operational research. Management science; Option pricing; Portfolio theory; Probability; Quadratic programming; Risk-neutral density estimation; Securities prices; Semidefinite programming; Stochastic models; Studies
• ISSN: 0377-2217; 1872-6860
• DOI: 10.1016/j.ejor.2007.02.041

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.