A Bayesian Time-Varying Approach to Risk Neutral Density Estimation

42 Pages Posted: 21 Jun 2015

See all articles by Roberto Casarin

Roberto Casarin

University Ca' Foscari of Venice - Department of Economics

German Molina

Idalion Capital US LP

Enrique ter Horst

Universidad de los Andes, Colombia - School of Business Administration

Date Written: June 20, 2015

Abstract

In this paper we expand the literature of risk neutral density estimation across maturities from implied volatility curves, usually estimated and interpolated through cubic smoothing splines. The risk neutral densities are computed through the second derivative as in Panigirtzoglou and Skiadopoulos (2004), which we extend through a Bayesian approach to the problem, featuring: (1) an extension to a multivariate setting across maturities and over time; (2) a flexible estimation approach for the smoothing parameter, traditionally assumed common to all assets, known and fixed across maturities and time, but now potentially different between assets and maturities, and over time; and (3) information borrowing about the implied curves and risk neutral densities not only across different option maturities, but also dynamically.

Keywords: Bayesian Inference, Cubic Smoothing Splines, Dynamic Linear Models, Nonparametric Risk-Neutral Densities, Smoothing Parameter Estimation

JEL Classification: C1, C5, C58

Suggested Citation

Casarin, Roberto and Molina, German and ter Horst, Enrique, A Bayesian Time-Varying Approach to Risk Neutral Density Estimation (June 20, 2015). Available at SSRN: https://ssrn.com/abstract=2621108 or http://dx.doi.org/10.2139/ssrn.2621108

Roberto Casarin (Contact Author)

University Ca' Foscari of Venice - Department of Economics ( email )

San Giobbe 873/b
Venice, 30121
Italy
+39 030.298.91.49 (Phone)
+39 030.298.88.37 (Fax)

HOME PAGE: http://sites.google.com/view/robertocasarin

German Molina

Idalion Capital US LP ( email )

2711 Centerville Rd Ste 400
Wilmington, DE 19808
United States

Enrique ter Horst

Universidad de los Andes, Colombia - School of Business Administration ( email )

Bogota
Colombia

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