Testing the Stability of Implied Probability Density Functions

BOE Working Paper No. 114

52 Pages Posted: 22 Nov 2000

See all articles by Robert R. Bliss

Robert R. Bliss

affiliation not provided to SSRN

Nikolaos Panigirtzoglou

Queen Mary, University of London

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Abstract

Implied probability density functions (PDFs) estimated from cross-sections of observed option prices are gaining increasing attention amongst academics and practitioners. To date, however, little attention has been paid to the robustness of these estimates or to the confidence that users can place in the summary statistics (for example the skewness or the 99th percentile) derived from fitted PDFs. This paper begins to address these questions by examining the absolute and relative robustness of two of the most common methods for estimating implied PDFs - the double-lognormal approximating function and the smoothed implied volatility smile methods. The changes resulting from randomly perturbing quoted prices by no more than a half tick provide a lower bound on the confidence intervals of the summary statistics derived from the estimated PDFs. Tests are conducted using options contracts tied to short sterling futures and the FTSE 100 index - both trading on the London International Financial Futures and Options Exchange. The tests show that the smoothed implied volatility smile method dominates the double-lognormal as a technique for estimating implied PDFs when average goodness-of-fits for both methods are comparable.

JEL Classification: C12, C13

Suggested Citation

Bliss, Robert R. and Panigirtzoglou, Nikolaos, Testing the Stability of Implied Probability Density Functions. BOE Working Paper No. 114, Available at SSRN: https://ssrn.com/abstract=230786 or http://dx.doi.org/10.2139/ssrn.230786

Robert R. Bliss (Contact Author)

affiliation not provided to SSRN

Nikolaos Panigirtzoglou

Queen Mary, University of London ( email )

Mile End Road
London, London E1 4NS
United Kingdom