University of Washington
NBER Working Papers and Publications
|May 2002||Nonparametric Option Pricing under Shape Restrictions|
with Yacine Ait-Sahalia: w8944
Frequently, economic theory places shape restrictions on functional relationships between economic variables. This paper develops a method to constrain the values of the first and second derivatives of nonparametric locally polynomial estimators. We apply this technique to estimate the state price density (SPD), or risk-neutral density, implicit in the market prices of options. The option pricing function must be monotonic and convex. Simulations demonstrate that nonparametric estimates can be quite feasible in the small samples relevant for day-to-day option pricing, once appropriate theory-motivated shape restrictions are imposed. Using S&P500 option prices, we show that unconstrained nonparametric estimators violate the constraints during more than half the trading days in 1999, unlike ...
Published: Journal of Econometrics, 2003, vol. 116, pp. 9-47 citation courtesy of