The Federal Reserve Board eagle logo links to Board's home page

International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Interpreting the Volatility Smile: An Examination of the Information Content of Option Prices
Steven Weinberg
2001-706  (August 2001)

Abstract:  This paper evaluates how useful the information contained in options prices is for predicting future price movements of the underlying assets. We develop an improved semiparametric methodology for estimating risk-neutral probability density functions (PDFs), which allows for skewness and intertemporal variation in higher moments. We use this technique to estimate a daily time series of risk-neutral PDFs spanning the late 1980's through 1999, for S&P 500 futures, U.S. dollar/Japanese yen futures and U.S. dollar/deutsche mark futures, using options on these futures. For the foreign exchange futures, we find little discernable additional information contained in the estimated PDFs beyond the information derived from the Black-Scholes model, a fully parametric specification. For S&P 500 futures, we find that the risk-neutral distribution implied by the volatility smile better fits the realized returns than the Black-Scholes model, although this better overall fit is not exhibited in the second and third moments.

Full paper (685 KB PDF)

foreign exchange, derivative asset pricing, probability density functions

PDF files: Adobe Acrobat Reader   ZIP files: PKWARE

Home | IFDPs | List of 2001 IFDPs
To comment on this site, please fill out our feedback form.
Last update: August 9, 2001