Staff Working Paper No. 66
By Bhupinder Bahra
Derivative markets provide monetary authorities with a rich source of information for gauging market sentiment. For example, a futures price is the possible to derive the higher moments of future asset values from the market prices of options. These can be extracted in the form of a risk-neutral probability distribution of the underlying asset price at the maturity date of the options. In this paper we develop various techniques for estimating the market’s ex ante risk-neutral probability density function of an underlying asset price from the prices of options on that asset. We then illustrate the potential value of this type of information to the policy-maker in assessing monetary conditions, monetary credibility, the timing and effectiveness of monetary operations, and in identifying anomalous market prices.
Implied risk-neutral probability density functions from option prices: theory and application