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A Simple and Reliable Way to Compute Option-Based Risk-Neutral Distributions
June 2014 Number 677
JEL classification: G01, G13, G17, G18
Allan M. Malz
This paper describes a method for computing risk-neutral density functions based on the option-implied volatility smile. Its aim is to reduce complexity and provide cookbook-style guidance through the estimation process. The technique is robust and avoids violations of option no-arbitrage restrictions that can lead to negative probabilities and other implausible results. I give examples for equities, foreign exchange, and long-term interest rates.