NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices

Yacine Ait-Sahalia, Andrew W. Lo

NBER Working Paper No. 5351
Issued in November 1995
NBER Program(s):   AP

Implicit in the prices of traded financial assets are Arrow- Debreu state prices or, in the continuous-state case, the state-price density (SPD). We construct an estimator for the SPD implicit in option prices and derive an asymptotic sampling theory for this estimator to gauge its accuracy. The SPD estimator provides an arbitrage-free method of pricing new, more complex, or less liquid securities while capturing those features of the data that are most relevant from an asset-pricing perspective, e.g., negative skewness and excess kurtosis for asset returns, volatility 'smiles' for option prices. We perform Monte Carlo simulation experiments to show that the SPD estimator can be successfully extracted from option prices and we present an empirical application using S&P 500 index options.

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Document Object Identifier (DOI): 10.3386/w5351

Published: The Journal of Finance, Vol. 53, no. 2 (April 1998): 499-547.

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