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Annual Review of Financial Economics

Volume 10, 2018

Risk-Neutral Densities: A Review

Abstract

Trading in options with a wide range of exercise prices and a single maturity allows a researcher to extract the market's risk-neutral density (RND) over the underlying price at expiration. The RND contains investors’ beliefs about the true probabilities blended with their risk preferences, both of which are of great interest to academics and practitioners alike. With a particular focus on US equity options, I review the historical development of this powerful concept, practical details of fitting an RND to options market prices, and the many ways in which investigators have tried to distill true expectations and risk premia from observed RNDs. I briefly discuss areas of active current research including the pricing kernel puzzle and the volatility surface, and offer thoughts on what has been learned about RNDs so far and fruitful directions for future research.

Keyword(s): implied volatility, JEL G12, JEL G13, JEL G14, JEL G17, option pricing, option risk premia, risk-neutral densities
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2018-11-01
2024-04-30
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/content/journals/10.1146/annurev-financial-110217-022944
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Risk-Neutral Densities: A Review
Annual Review of Financial Economics 10, 329 (2018); https://doi.org/10.1146/annurev-financial-110217-022944
/content/journals/10.1146/annurev-financial-110217-022944
/content/journals/10.1146/annurev-financial-110217-022944
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