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Closed-form transformations from risk-neutral to real-world distributions

Liu, Xinzhong, Shackleton, Mark B., Taylor, Stephen J. and Xu, Xinzhong 2007. Closed-form transformations from risk-neutral to real-world distributions. Journal of Banking & Finance 31 (5) , pp. 1501-1520. 10.1016/j.jbankfin.2006.09.005

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Risk-neutral and real-world densities are derived from option prices and risk assumptions, and are compared with historical densities obtained from time series. Two parametric risk-transformations are used to convert risk-neutral densities into real-world densities. Both transformations are estimated by maximizing the likelihood of observed index levels, for two parametric density families. Results for the FTSE-100 index show that parametric densities derived from option prices have more explanatory power than historical densities and higher likelihoods than densities estimated by spline methods. A combination of parametric real-world and historical densities provides the preferred predictive densities.

Item Type: Article
Date Type: Publication
Status: Published
Schools: Business (Including Economics)
Uncontrolled Keywords: Generalized beta; Lognormal mixture; Real-world density; Risk-neutral density
ISSN: 03784266
Last Modified: 18 Oct 2017 10:34

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