Closed-form Transformations from Risk-neutral to

Real-world Distributions

Xiaoquan Liu*, Mark B Shackleton*,

Stephen J Taylor* and Xinzhong Xu**

*Department of Accounting & Finance, Lancaster University

**Guanghua School of Management, Peking University

December 2002
Revised May 2003

Contact information for correspondence :

Stephen J Taylor, Department of Accounting & Finance, Management School,

Lancaster University, England LA1 4YX, telephone + 44 1524 593624, e-mail
S.Taylor@lancaster.ac.uk

Closed-form Transformations from Risk-neutral to

Real-world Distributions

Abstract

Risk-neutral (RN) and real-world (RW) densities are derived from option prices and
risk assumptions, and are compared with densities obtained from historical time
series. Two parametric methods that adjust from RN to RW densities are investigated,
firstly a CRRA risk aversion transformation and secondly a statistical calibration.
Both risk transformations are estimated using likelihood techniques, for two flexible
but tractable density families. Results for the FTSE-100 index show that densities
derived from option prices have more explanatory power than historical time series.
Furthermore, the pricing kernel between RN & RW densities may be more regular
than previously reported and a more reasonable risk aversion function is estimated.

Closed-form Transformations from Risk-neutral to

Real-world Distributions

1. Introduction

Options prices provide a rich source of information for estimating risk-neutral

densities (RNDs) because a complete set of strikes can be used to infer the
distribution of the underlying asset price when the options expire. As a result many
density specifications have been estimated from options prices. Parametric
specifications include a mixture of lognormals [Ritchey (1990), Melick and Thomas
(1997)], polynomials multiplied by a lognormal [Madan and Milne (1994)], a
generalized beta [Anagnou, Bedendo, Hodges and Tompkins (2002)] and the densities
of continuous-time price processes when volatility is stochastic [Bates (2000),
Jondeau and Rockinger (2000)]. Other approaches include maximum entropy
densities [Buchen and Kelly (1996)], non-parametric estimates [Ait-Sahalia and Lo
(1998)], multi-parameter discrete distributions [Jackwerth and Rubinstein (1996)] and
densities implied by smile functions, defined by either polynomials [Shimko (1993),
Malz (1997)] or spline functions [Bliss and Panigirtzoglou (2002a)].

In recent years, however, attention has shifted to the relationship between riskneutral densities and real-world densities 1 . One strand of literature investigates
methods that transform RNDs into real-world densities [Anagnou et al (2002),
Bakshi, Kapadia and Madan (2003), Bliss and Panigirtzoglou (2002b)]. These
methods are important for central bankers and other decision takers who wish to infer
market beliefs about future distributions from market prices. Another strand uses
RNDs and real-world densities obtained from historical time series of asset returns to
obtain insights into empirical asset pricing kernels and the aggregate risk preferences
of market participants [Jackwerth (2000), Ait-Sahalia and Lo (2000), Perignon and
Villa (2002), Rosenberg and Engle (2002), Brown and Jackwerth (2002)]. The results
are also important for assessments of the rationality of option prices.
This paper also explores the relationships between risk-neutral distributions,
real-world distributions, aggregate market risk preferences and empirical pricing
kernels. We provide answers to two questions (a) how can real-world densities be
calculated rapidly from option prices ?, (b) are these densities more informative than
those provided by historical time series ?. There are also two primary methodological
contributions. First, two parametric closed-form methods are used to obtain real-world
distributions from RNDs, namely a utility transformation and a statistical calibration
transformation. Our RNDs are obtained both from a mixture of two lognormal
densities and a generalized beta density, which results in four series of real-world
densities that incorporate risk factors. Second, maximum likelihood estimation (MLE)

The adjectives real-world, risk-adjusted and subjective are used interchangeably in the research literature.
They all refer to price distributions in which market risk preferences are embedded.

is used to efficiently estimate the transformation parameters and to compare the loglikelihoods of risk-adjusted distributions with those of historical distributions obtained
by simulation of an asymmetric GARCH model.
Our paper is most closely related to the contemporaneous research of Anagnou
et al (2002) and Bliss and Panigirtzoglou (2002b). These papers only consider the
utility transformation and they do not use MLE to estimate their risk aversion
parameters : Bliss and Panigirtzoglou use indirect estimates based upon calibration
concepts, while Anagnou et al evaluate parameter values but do not estimate them.
Historical real-world densities are not compared with option densities by Bliss and
Panigirtzoglou. Comparisons are made by Anagnou et al but they do not compare the
likelihoods of their sets of densities.
Risk-neutral and historical densities provide sufficient information to estimate
representative risk aversion functions. We obtain the first estimates of these functions
for the U.K. equity market, complementing the studies of the U.S. market by
Jackwerth (2000), Ait-Sahalia and Lo (2000) and Rosenberg and Engle (2002) and of
the French market by Perignon and Villa (2002). The most detailed analysis is by
Rosenberg and Engle (2002) who estimate the empirical pricing kernel on a daily
basis for the S&P 500 index, so as to capture time-varying features in RNDs and realworld densities. They fit a semi-parametric spline function to the implied volatility
smile, to obtain risk-neutral densities, and estimate an asymmetric GARCH model for
index returns allowing Monte Carlo simulations of real-world distributions. They find
that empirical pricing kernels are time-varying, are generally downward sloping and

that the assumption of constant relative risk aversion (CRRA) is not an accurate
depiction of actual market risk preferences.
The empirical results in this paper are obtained from FTSE-100 futures and
options contracts traded in London that cover the period from 1993 to 2000. The
results show that the real-world densities defined by utility transformed RNDs and
statistically calibrated RNDs have significantly higher log-likelihoods than the RNDs
themselves. Also, the log-likelihoods of the RNDs and their transformed densities
exceed those for historical distributions and hence option prices contain incremental
information about real-world distributions. The average empirical pricing kernel for
the London market is found to be generally downward sloping and does not exhibit
the hump shape observed by Brown and Jackwerth (2002). However, the implied risk
aversion and relative risk aversion are U-shaped, an anomaly also found by Jackwerth
(2000) and Ait-Sahalia and Lo (2000) that confronts economic theory.
The paper is organized as follows. Section 2 describes parametric risk-neutral
densities that can be transformed into closed-form real-world densities. Section 3
documents the transformations and explains how their parameters can be estimated.
Section 4 explains data processing for options written on the FTSE 100 index and
summarizes the derivation of the risk-neutral and real-world densities. Section 5
discusses the estimated densities and measures of risk aversion in the context of
recent research. Finally, Section 6 concludes.

2. Theoretical risk-neutral densities

Breeden and Litzenberger (1978) show that a unique risk-neutral density g for a
subsequent asset price S T can be inferred from European call prices c( X ) when
contracts are priced for all strikes X and there are no arbitrage opportunities. The riskneutral density (RND) is then
g ( X ) = e rT

2c
X 2

(1)

and

c( X ) = e rT ( x X ) g ( x )dx

(2)

with r the risk-free rate and T the time remaining until all options expire. The forward
price F, for time T, is the risk-neutral expectation of S T ; it is also a futures price,
assuming non-stochastic interest rates and dividend payments. These relationships
between the RND and derivative prices are the basis for empirical derivations of
implied RNDs, despite the impossibility of obtaining option data for a continuum of
strikes.
Two parametric families of RNDs are estimated in this paper. Once a month,
and for each family, a parameter vector is estimated by minimizing the average
squared difference between observed market prices and theoretical option prices,
namely
1 N
( X j ) c ( X j | )) 2 ,
(c
N j =1 market

(3)

with c( X j | ) = e rT ( x X j ) g ( x | )dx , 1 j N .
X

(4)

In these equations, N is the number of prices obtained from option quotes or trades
during a particular day and g ( x ) is a parametric density function that produces the
theoretical option pricing formula c( X ) given by equation (2). We choose specific
parametric densities for the RNDs because they enable us to obtain closed-form realworld densities. Other families of RNDs, including non-parametric specifications, will
provide similar empirical results whenever the range of the exercise prices is wide
enough to enclose almost all of the estimated densities.

2.1 Mixture of lognormal densities

Following Ritchey (1990) and Melick and Thomas (1997), the density of the
asset price when options expire can be defined as a mixture of lognormal densities
(hereafter MLN). The MLN densities are flexible and easy to estimate, with the
possibility of giving an economic interpretation to the parameters when the
component densities are determined by specific states of the world when the options
expire.
The density function in this study is a linear combination of two lognormal
densities, g LN , with weights w and 1 w ,
g MLN ( x ) = wg LN ( x | F1 , 1 , T ) + (1 w) g LN ( x | F2 , 2 , T )

with

(5)

1 2

x
F

T
]
log(
)

[log(
)

1
1
2

g LN ( x | F , , T ) =
exp
.

2
x 2T
T

(6)

The parameter vector is = ( F1 , F2 , 1 , 2 , w ) . The parameters F1 , 1 and w denote

the mean, volatility and weight of the first lognormal density and likewise F2 , 2
and 1 w are the mean, volatility and weight of the second lognormal density. The
theoretical European option pricing formula is simply a weighted average of two
prices given by Blacks formula, with weights w and 1 w ,
c( X | , r , T ) = wc B ( F1 , T , X , r, 1 ) + (1 w)c B ( F2 , T , X , r , 2 ) .

(7)

There are three constraints on the parameter values : first, 0 w 1 , to ensure the
mixture density is always positive; second, wF1 + (1 w) F2 = F , the constraint that
the risk-neutral expectation equals the current futures price F; and third,
F1 , F2 , 1 , 2 > 0 .

The mixture density avoids the rigid shape of a single density because it has
three additional free parameters; the risk-neutral constraint reduces the free
parameters of the mi xture to four, compared with only one for a single risk-neutral
lognormal. The standard deviation, skewness and kurtosis of the mixture can be
derived from

1
1
E[S Tn ] = wF1n exp( ( n 2 n) 12T ) + (1 w) F2n exp( ( n 2 n) 22 T ) .
2
2

(8)

2.2 Generalized beta density

The generalized beta distribution of the second kind (hereafter GB2) was first
proposed by Bookstaber and McDonald (1987) and is utilized by Anagnou et al

(2002). The GB2 density incorporates four positive parameters, = (a , b, p , q ) , that

permit general combinations of the mean, variance, skewness and kurtosis of a
positive random variable, thus enabling the shape of the density to be flexible. The
GB2 density function is defined as

g GB 2 ( x | a, b, p, q) =

x ap1

p+q
b ap B ( p, q)
x a
1
+
(
)

, x > 0,

(9)

with B( p, q ) = ( p )( q) / ( p + q ) .
The density is risk-neutral when

F=

1
1
,q )
a
a
B ( p, q )

bB ( p +

(10)

and its moments are

E[S Tn ] =

n
n
,q )
a
a for n < aq .
B( p, q)

b n B( p +

(11)

The parameter b is seen to be a scale parameter, while the product of a and q

determines the maximum number of moments and hence the asymptotic shape of the
tails; moments do not exist when n aq .
The theoretical option pricing formula depends on the cumulative distribution
function (c.d.f.) of the GB2 density, denoted GGB 2 , which is a function of the c.d.f. of
the beta distribution, denoted G and also called the incomplete beta function :
GGB 2 ( x | a, b, p, q ) = GGB 2 (( x / b )a 1,1, p, q ) = G ( z( x, a, b) p, q)

(12)

with z( x, a , b) = ( x / b)a (1 + ( x / b) a ) . If the density is risk-neutral, so that the

constraint in equation (10) applies, then European call option prices are given by

10

c( X ) = e rT ( x X ) g GB 2 ( x | a, b, p , q )dx

(13)

1
1

= Fe rT 1 GGB 2 ( X | a, b, p + , q ) Xe rT [1 GGB 2 ( X | a , b, p , q )]
a
a

1
1

= Fe rT 1 G z ( X , a , b) | p + , q Xe rT 1 G (z( X , a , b ) | p, q ) .
a
a

3. Theoretical real-world densities

All expected returns equal the risk-free rate in a risk-neutral economy. Risk-neutral
investors do not require a premium to induce them to bear risks and therefore all
derivatives can be priced regardless of the market risk preference. When we change
our attention from a risk-neutral economy to the real-world economy, the discount
rate for asset payoffs changes. It then involves a risk factor that is associated with the
sentiment of investors over future price uncertainties and their relationship with a
market portfolio. Correspondingly, risk preferences need to be taken into account in
estimating real-world price distributions. This can be achieved by transforming the
risk-neutral density (often called a Q density) into the real-world density (the P
density) by making a risk adjustment. Two parametric methods are evaluated in this
paper. One transformation is motivated by a representative utility function and the
other involves statistical calibration. The two transformations are applied to RNDs
that are MLN or GB2 densities. Both transformations provide closed-form real-world
densities whose transformation parameters can be estimated by maximizing the

11

likelihood of real-world observations. Furthermore, for both our selected RND

methods the densities remain in the same family after the utility transformation.

3.1 A utility transformation

Let M ( ST ) be the stochastic discount factor, or pricing kernel, for payoffs at
a future time T. With sufficient assumptions, reviewed by Ait-Sahalia and Lo (2000),
Jackwerth (2000) and Rosenberg and Engle (2002), the stochastic discount factor is
proportional to the marginal utility of a representative agent,

M (x) =

d
dx

(14)

with an irrelevant constant and the representative utility function. European

option prices are real-world discounted option payoffs, given by

c( X ) = E P [M ( ST ) max( ST X ,0)] = M ( x )(x X ) g~( x )dx

(15)

for the real-world density g~( x ) and also by the risk-neutral formula

c( X ) = e rT E Q [max( ST X ,0)] = e rT ( x X ) g ( x) dx.

(16)

Consequently,
g ( x)
M ( x) = e rT ~ .
g (x)

(17)

From (14) and (17), it can be seen that the risk-neutral density g, the real-world
density g~ , and the utility function are linked by

g ( x ) ( x )
g~( x ) =
.
g ( y )dy ( y )
0

We assume the representative agent has a power utility function,

(18)

12

x1
, 0 but 1 ,
(x) =
1

(19)

= log( x) , when = 1 ,
with the risk aversion parameter. The marginal utility is then ( x) = x and the
relative risk aversion function is a constant : RRA( x) = x ( x) ( x) = . The realworld density then becomes
g~( x ) =

x g ( x)

(20)

y g ( y) dy

Note that if g is lognormal then so is g~ . The volatility parameters of g and g~

are then equal but their expected values are respectively F and F exp( 2T ) for the
parameterization defined by equation (6). From this result for one lognormal density,
it is apparent that a transformed mixture of two lognormals is also a mixture of two
lognormals. For a risk-neutral mixture density g MLN ( x ) given by equation (5),
with = ( F1 , F2 , 1 , 2 , w ) , it can be shown that the real-world density is
~
g~( x , ) = g MLN ( x )
with

~
~ ~
~) ,
= (F1, F2 , 1 , 2 , w
~
Fi = Fi exp( i2T ) , for i = 1, 2 ,
and
1
1 w F2
1
1
( ) exp( ( 2 )( 22 12 )T ) .
=
+
~
w
w F1
2

(21)

13

Likewise, it is easy to show that the utility transformation changes a GB2 density into
another GB2 density. For the density g GB 2 ( x ) given by equation (9), with

= (a , b, p , q ) , the real-world density is

~
g~( x , ) = g GB 2 ( x )

(22)

with

= ( a, b, p + , q ) ,
a
a
assuming aq > .

3.2 Statistical calibration

Let G and G 1 initially denote any cumulative distribution function (c.d.f.)
and its inverse function. Also let Gactual be the actual, but unknown, c.d.f. of S T .
Observe that the c.d.f. of the random variable U = G (S T ) is

Prob(U u ) = Prob( ST G 1 (u )) = Gactual (G 1 (u )) for 0 u 1 .

(23)

The two c.d.f.s G and Gactual are identical when the density of S T is correctly
specified, and then P(U u ) = u . Thus U is uniformly distributed between 0 and 1 if
and only if the density of S T is correctly specified.
Furthermore, suppose density g i is produced at time t i for the asset price at
time t *i with t i* ti +1 . Then the stochastic process {U i } is i.i.d., with the above
uniform distribution, when all the densities are correctly specified. The two
assumptions of uniformity and independence can be checked either separately
[Diebold et al (1998)] or jointly by using tests described in Berkowitz (2001). The

14

data for these tests are given by the cumulative probabilities u i = Gi (S T ,i ) , evaluated
at asset prices S T , i observed at the times t *i .
Fackler and King (1990) describe a recalibration method that improves a set of
densities when they are judged against the assumption that the random variables
defined by their c.d.f.s are uniformly distributed. Their method can be used to directly
transform risk-neutral densities into real-world densities; they do this for lognormal
RNDs obtained from a variety of commodity options. The key assumption when
recalibrating densities is that the u i are observations from a common probability
distribution.
Now let g and G respectively denote the RND and the cumulative distribution
function of a particular S T . For the random variable U = G ( ST ) , let its real-world
c.d.f. be the calibration function C (u ) = Prob(U u ) . The random variable C (U ) has
a uniform real-world distribution because
Prob(C (U ) u ) = Prob(U C 1 (u )) = C (C 1 (u )) = u .
~
~
Define the calibrated real-world c.d.f. G and another random variable U by

~
~ ~
G ( x) = C(G( x )) and U = G (S T ) = C (G (S T )) = C (U ) .

(24)

~
~
Then U is uniformly distributed and hence G is correctly specified. However, the

function C is unknown.
Fackler and King (1990) recommend the c.d.f. of the Beta distribution as a
candidate calibration function,
u

C (u ) = v j 1 (1 v) k 1 dv / B( j , k ) .
0

(25)

15

This parametric distribution is defined on the interval [0, 1] and has a flexible shape.
The uniform distribution is a special case ( j = k = 1 ) that is appropriate when the
original density g does not require recalibration. From (24) and (25), the calibrated
real-world density is

~
dG ( x) d
dC dG G ( x) j 1 (1 G( x)) k 1
~
= C(G( x )) =
=
g (x) =
g ( x) .
dx
dx
dG dx
B ( j, k )

(26)

This real-world density has a closed-form when g is either a GB2 density or a mixture
of lognormal densities, because G has a closed-form in both cases. The two
parameters j and k permit transformations from g to g~ that change the location,
volatility, skewness and kurtosis between densities. The possibility j > k > 1 is of
particular interest and corresponds to a transformation that reduces volatility and
negative skewness for our data.

3.3 Estimation of the transformation parameters

Estimates of the risk aversion parameter and the calibration parameters j
and k can be obtained by maximizing the likelihood of the observed asset levels
when options expire. For expiry time t *i , densities are evaluated at asset prices
denoted by S T , i . Providing the densities do not overlap, so they are formed at times
t i with t i < ti* ti +1 , the likelihood of a set of observed asset prices is simply the
product of density values. The required log-likelihood function for a set of n densities
is
n
log( L( ST ,1 , ST , 2 ,..., ST , n * )) = log( g~i (ST , i * ))
i =1

(27)

16

with * the transformation parameter(s), either or ( j, k ) . This function can be

maximized to provide the ML estimate of * .
The log-likelihood of a set of RNDs is obtained when there is no
transformation, so = 0 or j = k = 1 . Likewise, the log-likelihood of nonoverlapping real-world densities obtained from histories of asset returns is also given
by summing the logarithms of density values.

4. Empirical methods

4.1 Data
The futures and options data used in this study were obtained from the London
International Financial Futures and Options Exchange (LIFFE). The contracts are
written on the FTSE 100 index. Daily tick data for bid quotes, ask quotes and actual
trades are used. The averages of bid and ask prices are employed to avoid bid-ask
bounce effects. The data covers the 83 months from June 1993 to April 2000 inclusive
and includes prices from both American options (until November 1995) and European
options (from December 1995). The data used are switched from American to
European options when the trading volume of European options overtook that of their
American counterparts.
Risk-free interest rates were collected from DataStream. We prefer the London
Eurocurrency rate to the UK Treasury bill rate, because the Eurocurrency rate is a
market rate accessible to triple-A corporate borrowers.

17

The options are written on the spot index. Futures and options having the same
expiry month share a common expiry time, at 10:30 a.m. on the third Friday.
European options can then be valued by assuming that they are written on the futures
contract, and hence spot levels of the index are not needed.

4.2 Empirical risk-neutral densities

On a set of 83 prediction days t i , one per month, risk-neutral densities g i are
constructed for expiry days t *i . The days t *i refer to the third Friday of every month,
when the index options expire, while each t i is selected to be exactly four weeks 2
before t *i . Fixing the option lives at four weeks gives us 83 non-overlapping data sets.
The non-overlapping structure is essential for our likelihood calculations.
Futures contracts, unlike the options, are traded for only one expiration date
each quarter, in March, June, September and December. Synthetic futures prices must
therefore be calculated for the remaining months. Fair futures prices are the future
value of the spot price minus the present value of dividends expected during the life
of the futures contract, i.e.
F = e rT ( S PV ( dividends)) .

(28)

We have obtained actual dividend payments for the 100 component companies of the
index from DataStream, and computed the present value of dividends by assuming
that future expected dividends can be approximated by actual dividend payments.
Either the actual spot level or the spot level implied by the nearest futures contract

We go back an additional day to acquire the data on the rare occasions that a holiday makes this necessary.

18

(and the dividends until it ceases trading) can be used in (28). These two approaches
are identical in theory but they are not empirically equivalent. The spot levels implied
by futures are preferred, particularly for two reasons. First, the futures implied level
has been claimed to lead the spot index level for various reasons [see, for example,
Stoll and Whaley (1990) and Booth et al (1999)]. Second, options are hedged using
futures and not the spot index.
Non-synchronous trading also requires attention. Since options with different
strikes trade at different times of the day, they contain information at each
corresponding point of time that makes it impossible to directly extract an RND at a
common time. It is therefore necessary to convert option prices to equivalent prices at
a chosen point of time; 10:30 a.m. is selected as the standard for synchronization as
options and futures expire at 10:30 a.m. on their final trading days.
On any prediction day there are several options prices for the same expiry day.
The implied volatility from each option is obtained from the observed option
premium c*market , exercise price X j , contemporaneous futures price F j , time to
maturity T and interest rate r , according to the formula of Black (1976) for European
call options on futures,
c*market ( X j ) = cB ( F j , T , X j , r , implied ( X j )) .

(29)

The futures price at 10:30 a.m. then replaces F j in the formula c B to provide the
synchronized market price of the option, cmarket( X j ) . For American options, the
approximate pricing formula of Barone-Adesi and Whaley (1987) is used to extract
the market implied volatility and hence to obtain a synchronized European option

19

price. All European put prices are converted to call prices using the put-call parity
equation.
Certain exclusion rules were applied to the raw bid, ask and trade prices, to
remove uninformative data and outliers. First, options violating the boundary
conditions for European and American options were deleted. Second, options which
are 100 index points or more in-the-money were deleted as these options have less
liquidity and depth. Third, repeated quotes, which are defined as quotes that are
exactly the same but appear within 30 minutes, were excluded for the reason that
keeping the redundant quotes would give undue weight to such quotes.
Finally, visual screening of the implied volatility smiles shows that a very
small number of extreme outliers ought to be removed because of their excessive
influence on the density estimates. In total 69 option prices are deleted, 63 for
midquotes and 6 for trades. These leave 30,341 options prices in all, with 18,832
midquotes and 11,509 trade prices. The summary statistics in Table 1 provide further
information about the moneyness of the options prices.
All our methods have been implemented for the averages of option bid and ask
quotes and for option trade prices. The two types of price data provide very similar
results and hence we concentrate upon the results obtained from the midquotes in the
following sections.

4.3 Summary statistics for densities obtained from option prices

Parameters are estimated for the two parametric density families, month by

20

month, by minimizing the average of the squared differences specified in equation (3).
Table 2 provides a summary of these averages for the two families and the 83
available months. These averages are very similar for the two density families. The
standard deviations of the option pricing errors implied by these summary statistics
are less than the typical bid-ask spread. Summary statistics for the moments of the
risk-neutral densities are presented in Table 5 and discussed later in Section 5.1.
Figure 1 shows typical estimates of the risk-neutral densities. They exhibit a marked
negative skewness that has often been reported for equity indices.
Most RND estimation methods give similar results within the range of
exercise prices that provide the market data, because the implied volatility smile is
typically a smooth function that can be approximated by a low-order polynomial. All
methods must extrapolate outside the available range of the data and their tail shapes
will depend on the type of densities chosen. Our empirical conclusions are probably
insensitive to the RND method because there are almost no outcomes in the regions of
extrapolation. The probability within the range of exercise prices for our RNDs is
always more than 90%. Table 3 gives typical probabilities for four expiry dates, most
of which exceed 98%.
Table 4 includes estimates of the parameters used to transform the risk-neutral
densities into real-world densities. It also includes the maximized values of the loglikelihood function. The results are shown under the heading = 1 . They are robust
with respect to data and density choices, being similar for midquote and trade prices
and also for MLN and GB2 and densities. The MLEs of the CRRA parameter are

21

all near four. For the calibration transformation, all the MLEs are near 1.4 for j and
1.1 for k. The statistical significance of the log-likelihood increases, given by
transforming the densities, is discussed later in Section 5.3. Figure 2 illustrates a
typical GB2 risk-neutral density and the two derived real-world densities. The same
comparisons are shown for densities obtained from lognormal mixtures on Figure 3.

4.4 Historical real-world densities

It is important to compare the log-likelihood of densities obtained from
historical returns with those obtained from options prices. The real-world option
densities must outperform historical densities if they are to be recommended as realworld predictive densities. ARCH models for daily index returns are here estimated
and simulated to provide historical real-world densities. The simulated ARCH models
must accommodate the stylized facts documented in the literature, including a timevarying conditional mean, a persistent conditional volatility and an asymmetric
response of volatility to positive and negative returns. We choose the GJRGARCH(1,1)-MA(1)-M specification, following Glosten, Jagannathan and Runkle
(1993) and Engle and Ng (1993). The conditional mean t and the conditional
variance ht of the daily index return rt are as follows,

ht = + ht 1 + ( + Dt 1 )(rt 1 t 1) 2 ,
t = + (ht 1)1 / 2 + (rt 1 t 1)
Dt = 1 if rt 0,
= 0 otherwise.

(30)

22

Ten years of daily index returns prior to each estimation date t i are used to estimate
the seven ARCH parameters, by maximizing the quasi-log-likelihood function which
assumes the conditional distributions are normal. These estimates are consistent when
the normality assumption is false (Bollerslev and Wooldridge (1992)).
The parameters obtained from information up to time t i are used to simulate
the ARCH equations until time t *i . Ten thousand simulations of the final asset level

S T , i are obtained for each month i. The historical real-world density g~i is then the
smooth function obtained by using the Gaussian kernel with bandwidth

H=

0.9
5 10000

(31)

and with the standard deviation of the simulated final levels. Figure 1 shows a
typical historical real-world density. The bandwidth H should be carefully chosen.
Bands that are too wide create oversmooth densities, while narrow bands can create
spurious multimodalities. Our value follows Silverman (1986, page 48) and it is half
the bandwidth used in Jackwerth (2000), which we consider may lead to oversmoothing.
The log-likelihood of the historical densities is evaluated at the same stock
index levels as the option densities, using the same function defined by equation (29).
Table 4 shows that the historical log-likelihood is slightly less than that obtained from
each of the sets of RNDs. Summary statistics for the moments of the historical realworld densities are included in Table 5. Most of the skewness values are near zero,
with the average skewness slightly negative. This occurs because the asymmetric
volatility parameter in equation (30) is always positive. Most of the kurtosis

23

values are in the vicinity of four, which reflects the uncertain average level of
volatility during the four-week periods covered by the simulations.

5. Comparisons and discussion

Comparisons of the risk-neutral densities, the risk-adjusted densities and the historical
densities are performed using three sets of statistics. First we compare the moments of
the density functions, then we compare the cumulative probabilities of the realized
index levels S T , i and finally we compare the log-likelihoods of these levels.

5.1 Comparison of the moments of sets of densities

Table 5 summarizes the mean, standard deviation, skewness and kurtosis of
densities for random variables S T , i / Fi , produced on the prediction days t i when the
futures prices are Fi . Summary statistics are provided for seven sets of 83 densities.
The statistics are given for the GB2 and lognormal mixture RNDs, the two
transformations applied to each set of RNDs and the historical real-world densities.
The RNDs are obtained from midquotes.
The historical and the transformed densities have similar average standard
deviations that are slightly lower than the averages for the RNDs. However, the
dispersion of the standard deviations is much less for the historical densities and
reflects low estimates of the persistence of the ARCH conditional variances.

24

Almost all of the RNDs are negatively skewed, with the average skewness
about 0.7 for both sets of risk-neutral densities. The transformed real-world densities
are less skewed, with average levels between 0.6 and 0.5, that are far from the
average level of 0.1 for the historical real-world densities. The negative skewness in
the option-based densities is consistent with beliefs that there is more chance of a
substantial negative one-month return than of a corresponding substantial positive
return. Past experiences of crashes are reflected in option prices, although crash
anxieties may be unduly pessimistic when related to the ten-year histories of index
changes that define the historical densities.
The RNDs and their transformations are slightly more leptokurtic than the
historical densities. Overall, the risk adjustments alter the RNDs to make them more
similar to the historical real-world densities, in terms of all four moments. The utility
transformed and calibrated distributions are less volatile, less negatively skewed and
less leptokurtic.

5.2 Comparison of ranked cumulative probabilities

As previously stated in Section 3.2, evaluating the cumulative distribution
function for month i at S T , i produces a probability u i . The u i should be uniformly
distributed on the interval [0, 1] if the process that generates u i is well calibrated.
Thus a plot of the sample c.d.f., C (u ) , which is the proportion of the u i equal to or
less than u, should be near the 45-degree line when densities are well calibrated.
Figure 4 shows C (u ) for the GB2 midquote RNDs and its two sets of risk-adjusted

25

densities. Figure 5 shows C (u ) for the historical real-world densities, that appear to
be well calibrated.
For the RNDs, it is clearly seen that C (u ) is much less than u for small values
of u : there are relatively few realized index levels below the first quartiles of the
RNDs and the minimum of the 83 probabilities u i on Figure 4 is 0.093. The minima
for three further sets of RNDs are 0.091, 0.079 and 0.092, respectively for the
GB2/trade, MLN/midquote and MLN/trade combinations. The eight sets of riskadjusted densities are more satisfactorily calibrated in the left tail region, with the
minimum values of u i between 0.039 and 0.056. The minimum is only 0.003 for the
historical real-world densities.
A standard goodness-of-fit statistic for a set of densities is the KolmogorovSmirnov (KS) statistic defined as the maximum value of C (u) u . The KS statistic
for the historical densities equals 0.062. The KS statistics for the RNDs range from
0.097 to 0.118. They are all reduced by the transformations to real-world densities,
varying from 0.071 to 0.083 for the utility transformation and from 0.086 to 0.102 for
the calibration method. None of the maximum values occur in the left tail region. All
the KS statistics accept the null hypothesis of i.i.d. observations from a uniform
distribution at the 15% level.

5.3 Comparison of log-likelihoods

Several comparisons are made between the densities by referring to the loglikelihoods of various sets of densities, shown in Table 4. As the log-likelihoods are

26

central to our methodology, they are provided for option-based densities derived
separately from midquote and trade prices. Note immediately that the historical realworld densities have the least log-likelihood, which suggests that option prices
contain more information about real-world densities than the history of daily returns
themselves.
The log-likelihoods are always slightly higher for the lognormal mixtures than
for the GB2 densities. This may simply reflect the fact that each mixture density has
four free parameters, compared with three for each GB2 density. The calibrated realworld densities have higher log-likelihoods than the utility-adjusted densities, which
again may reflect the additional transformation parameter employed in the
transformation from RNDs to calibrated densities. The log-likelihoods are very
similar for the midquote and trade data, with a slight advantage for trades when using
the GB2 method and for midquotes when applying the lognormal mixture method.
Likelihood-ratio tests show that the transformed densities provide a significant
improvement upon the RNDs, when the significance level is 10%. The test statistics
are defined by twice the increase in the log-likelihood achieved by optimizing over
the transformation parameter(s). For comparisons of the RNDs with the utility
transformed densities, the four test values (for different types of data and different
density families) are 3.30, 3.32, 3.64 and 4.00. These all exceed the 10% asymptotic
critical value from 12 , but only one exceeds the 5% point. Likewise, the test values
are 5.64, 5.64, 5.80 and 6.16 when comparing RNDs with recalibrated densities. All
of these exceed the 10% point from 22 but again only one is beyond the 5% point.

27

The relatively high p-values for these tests can be attributed to the limited sample size
of 83 densities.
The set of historical real-world densities can be compared with a set of optiondensities by nesting the two sets within an encompassing family. We maximize the
likelihood of the densities
g combined ( x ) = g RND / RWD ( x ) + (1 ) g ARCH ( x)

(32)

as a function of . The results are shown in the final five columns of Table 4.
For the risk-neutral densities the maximum likelihood estimates of are 0.51
and 0.52 for the two GB2 sets, and 0.61 and 0.64 for the two MLN sets. The null
hypothesis = 0 is rejected by each of the log-likelihood-ratios at the 2% level;
twice the increase in the log-likelihood given by optimizing equals 6.06, 6.34, 6.89
and 7.67 for the four sets of RNDs. These tests show there is incremental predictive
information in the RNDs.
Comparisons of the historical and real-world option densities involve
maximizing the likelihood over and the transformation parameters (either or j
and k). The rejections of = 0 are then more decisive as the test values necessarily
increase. The other null hypothesis of interest, = 1 , is accepted at the 5% level for
all eight combinations of transformation (utility or calibration), density family (GB2
or MLN) and price type (midquote or trade). The test values are compared with 12
and are all less than one for the MLN densities; they vary from 0.88 to 3.38 for the
GB2 densities. These tests show the evidence for incremental predictive information
in the historical densities is not statistically significant. The MLEs of are higher

28

when the real-world densities replace the RNDs, with average estimates of 0.63 and
0.79 respectively for the GB2 and MLN densities.

5.4 Empirical pricing kernels and risk aversion

Constant relative risk aversion is assumed in the transformation from RNDs to
real-world densities via a power utility function. The four maximum likelihood
estimates of shown in Table 4 are 3.83, 3.84, 3.86 and 4.04 when = 1 . These are
very similar to the 3.94 estimated by Bliss and Panigirtzoglou (2002b), for options
with four weeks to expiry. Their FTSE 100 index options data commences in June
1992 and ends in March 2001. They obtain RNDs from a smooth volatility smile that
is a function of the option delta and then select to minimize the calibration test
criterion of Berkowitz (2001). All of the estimates of are rather high compared with
expectations from lognormal RNDs and real-world densities; then, for a typical equity
index premium of 6% per annum and a volatility of 15% per annum, the expectations
after equation (20) give = 0.06 0.15 2 = 2.67 . One way to reconcile the difference
is to assert that some options are consistently mispriced, especially out-of-the-money
put options, thereby creating excessive negative skewness that can only partially be
corrected by a high power in the utility function. This explanation implies the relative
risk aversion function is not constant across wealth levels.
Empirical pricing kernels have two components, RNDs obtained from the
options market and historical real-world densities obtained from index returns. These
densities come from different information sets. As options data are more informative

29

than the index history for U.S. markets (Christensen and Prabhala (1998), Fleming,
(1998), Blair et al (2001)), the issue of different information sets may be important
when interpreting empirical pricing kernels.
Two pricing kernels M ( x ) = e rT g ( x ) g~ ( x) are constructed for each option
expiry date, with g (x ) either the mixture RND or the GB2 RND and with g~( x) the
historical density from GARCH simulations. The geometric mean of each set of
kernels is computed to reduce noise created by the data and the different information
sets. We plot the geometric means of the two sets of ratios g ( yF ) g~( yF ) against the
moneyness variable y = x F on Figure 6. Both empirical kernels are generally
decreasing functions of x F , although they are almost flat at some points between
0.95 and 1. These results are very different to those of Brown and Jackwerth (2002).
They observe a very clear hump-shaped marginal utility function, using S&P 500 data
from April 1986 to December 1995, which challenges economic theory and indicates
that the representative agent is risk seeking in some wealth region.
The risk aversion function is defined by the first and second derivatives of the
utility function,
RA( x ) =

( x ) g~ ( x ) g ( x ) d
g~( x)
= ~

=
log(
).
( x)
g ( x ) g ( x ) dx
g (x)

(33)

The relative risk aversion is RRA( x ) = xRA( x) , evaluated by Jackwerth (2000) and
Ait-Sahalia and Lo (2000). Figure 7 shows the risk aversion and the relative risk
aversion functions plotted against moneyness. These functions are calculated from the
geometric means of RNDs divided by historical real-world densities. We observe a
downward sloping risk aversion function as far as x / F = 0.96 for the GB2 densities

30

and further to x / F = 1 for the lognormal mixture densities, then both risk aversion
functions steadily increase. These estimates are incompatible with power and other
rational utility functions, which predict monotonically decreasing risk aversion. Thus
the previous assumption of constant relative risk aversion is not a very accurate
depiction of the combined dataset of option prices and index levels.
Jackwerth (2000), Ait-Sahalia and Lo (2000) and Rosenberg and Engle (2002)
all estimate risk aversion functions once a month from one-month options data on the
S&P 500 index. Jackwerth (2000) finds that the risk aversion function is credible
before the 1987 crash but becomes U-shaped post-crash. He attributes this to
persistent mispricing of options. However, his smoothed estimates of historical realworld densities ignore stochastic volatility while his GARCH densities do not permit
negative skewness in monthly index returns. Ait-Sahalia and Lo (2000) use
overlapping data for the single year 1993. They rely on kernel estimates for both riskneutral and real-world densities and make the very strong assumption that the implied
volatility function is constant through time. Their relative risk aversion function is Ushaped and incompatible with a power utility function. Rosenberg and Engle (2002)
also estimate irrational risk aversion functions, obtaining negative estimates over the
range 0.96 x / F 1.02 during the period from 1991 to 1995. They show that risk
aversion is a time-varying function, that is counter-cyclical with a risk premium that is
low (high) near business cycle peaks (troughs).

31

6. Summary and conclusions

Option prices provide a rich source of information with regard to the future
distribution of the underlying asset price, particularly with respect to future volatility.
This information is here translated initially into a risk-neutral probability density,
assuming a parametric form that is either a mixture of two lognormal densities or a
generalized beta density. Investors do not require a risk premium in this risk-neutral
world.
In order to move from an artificial risk-neutral world to the real world, where
premia are earned for bearing risks, a risk aversion function is needed. We therefore
choose a parametric utility function and estimate the relative risk aversion, which is
assumed to be constant. We also statistically calibrate risk-neutral densities to obtain a
second set of real-world densities from option prices. Using the FTSE 100 index as a
proxy for the aggregate wealth process, the risk aversion estima tes from a power
utility function are found to be reasonable and robust to different risk-neutral
estimation methods. Both utility-transformed densities and calibrated densities exhibit
less skewness and kurtosis than risk-neutral densities. In addition, likelihood-ratio
tests show that the real-world densities have significantly higher log-likelihood values
than the risk-neutral densities.

Both sets of risk-neutral densities have higher

likelihoods than historical densities estimated from ARCH models and hence the realworld densities obtained from options prices are more informative than those obtained
from the time series history of the index.

32

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35

Table 1. Summary statistics for the dataset of FTSE-100 options prices.

Midquotes

Trades

Total Number
Calls
Puts

18832
9285 (49.3%)
9547 (50.7)

11509
5728 (49.8%)
5781 (50.2%)

Average number of prices per day

227

139

10% or less ITM options

ATM options
10% or less OTM options
Deep OTM options

3331 (17.7%)
1174 (6.2%)
12785 (67.9%)
1542 (8.2%)

2061 (17.9%)
859 (7.5%)
7880 (68.5%)
709 (6.2%)

Range of moneyness
Calls
Puts

[0.81, 1.04]
[0.97, 1.72]

[0.82, 1.34]
[0.97, 1.52]

The four moneyness categories are (1) options in-the-money by more than 1%, but by
less than 100 index points, (2) within 1% of being at-the-money, (3) 10% or less outof-the-money and (4) more than 10% out-of-the-money.

36

Table 2. Risk-neutral probabilities within the range of exercise prices.

Expiry Month

May, 1994
May, 1996
May, 1998
May, 2000

Lower Bound Upper Bound

2800
3475
4625
5325

3800
4075
6825
6925

Probability Captured
GB2

MLN

98.11%
98.22%
98.21%
94.43%

98.64%
98.08%
98.85%
93.57%

The tabulated probabilities are the total risk-neutral probability within the range of
exercise prices for which midquotes are available. The densities are evaluated four
weeks before the options expire.

37

Table 3. Summary statistics for the average squared errors from RNDs.

Quartile

GB2

MLN

Minimum
1st Quartile
2nd Quartile
3rd Quartile
Maximum
Mean
Standard Deviation

0.01
0.55
5.42
14.00
116.94
11.85
16.86

0.01
2.51
5.63
14.42
112.20
12.29
17.04

The summary statistics in each column are for the 83 values of the average of the
squared errors given by parametric density functions. The averages are defined by
minimizing the quantity in equation (3). The option prices are midquotes.

38

Table 4. Log-likelihoods and transformation parameters for risk-neutral, risk-adjusted,

historical and encompassing densities.

Panel A:
Historical densities

Panel B: Midquotes
RND
GB2
MLN
Utility transformed
GB2
MLN
Recalibrated
GB2
MLN
Panel C: Trades
RND
GB2
MLN
Utility transformed
GB2
MLN
Recalibrated
GB2
MLN

=0
L = -547.51

AL

=1
j

0.72
2.79
2.37
4.61

3.84
4.04

3.54
5.87

1.38
1.42

1.08
1.11

0.97
2.27
2.97
3.93

3.83
3.86

3.87
5.09

1.40
1.40

1.11
1.11

AL

Optimal
j

3.17
3.84

0.52
0.64

3.53
4.73

0.63
0.85

5.23
6.17

0.63
0.78

3.04
3.44

0.51
0.61

3.41
4.14

0.64
0.81

5.01
5.53

0.61
0.73

2.81
3.79
1.60
1.52

1.45
1.26

1.60
1.52

1.47
1.31

2.93
3.48

The adjusted log-likelihood, AL, is the log-likelihood, L, minus the log-likelihood

obtained from historical densities. The estimated parameters are for the utility
transformation and j and k for the recalibration transformation. The parameter is
the weight assigned to RNDs and risk-adjusted RWDs when they are combined with
historical ARCH densities:
g combined ( x ) = g RND / RWD ( x ) + (1 ) g ARCH .

39
Table 5. Moments for RNDs, risk-adjusted densities and historical real-world
densities, obtained from midquotes.

GB2
RND

MLN
Utility-

Recalibrated

RND

transformed

Historical
Utility-

Recalibrated

transformed

Mean/F
Minimum

1.006

1.006

0.964

0.965

0.987

1st Quartile

1.005

1.008

0.993

0.989

0.998

2nd Quartile

1.010

1.010

1.002

1.003

1.005

3rd Quartile

1.010

1.014

1.011

1.010

1.028

Maximum

1.040

1.026

1.022

1.022

1.041

Mean

1.011

1.011

1.000

1.001

1.010

Stand. Dev.

0.008

0.004

0.013

0.014

0.016

Minimum

0.027

0.025

0.022

0.027

0.026

0.021

0.036

1st Quartile

0.036

0.035

0.030

0.036

0.035

0.030

0.040

2nd Quartile

0.048

0.046

0.041

0.048

0.046

0.040

0.042

3rd Quartile

0.063

0.056

0.051

0.061

0.054

0.048

0.043

Maximum

0.116

0.093

0.094

0.112

0.091

0.091

0.063

Mean

0.051

0.047

0.042

0.050

0.046

0.041

0.042

Stand. Dev.

0.019

0.015

0.015

0.018

0.014

0.014

0.004

Minimum

-1.43

-1.35

-1.24

-1.30

-1.14

-1.13

-0.27

Stdev/F

Skewness
1st Quartile

-0.94

-0.78

-0.75

-0.87

-0.70

-0.71

-0.21

2nd Quartile

-0.75

-0.60

-0.56

-0.70

-0.59

-0.55

-0.15

3rd Quartile

-0.50

-0.35

-0.30

-0.53

-0.42

-0.32

0.08

Maximum

-0.16

0.08

0.19

0.40

0.66

0.59

0.51

Mean

-0.74

-0.58

-0.53

-0.69

-0.57

-0.52

-0.07

Stand. Dev.

0.28

0.27

0.28

0.28

0.29

0.29

0.17

Minimum

3.22

3.20

3.15

3.06

3.20

3.22

3.44

1st Quartile

4.13

3.98

3.79

3.64

3.78

3.74

3.73

2nd Quartile

4.69

4.52

4.39

3.97

4.24

4.19

3.88

3rd Quartile

5.07

4.92

4.74

4.51

4.78

4.75

4.08

Maximum

6.48

6.33

6.03

9.36

9.64

7.52

6.90

Mean

4.62

4.49

4.33

4.27

4.40

4.33

3.98

Stand. Dev.

0.66

0.64

0.63

1.05

0.93

0.78

0.45

Kurtosis

The summary statistics in each column are for 83 densities. The first two panels are
respectively for the mean and variance divided by the futures prices.

40

Figure 1. Risk-neutral densities from midquote option prices and historical densities
on March 21, 1997.

0.005

0.004

Density

0.003

0.002

0.001

0
3500

4000

4500

5000

Index Levels at Expiry

RND (GB2)

RND (MixLn)

historical

41

Figure 2. The risk-neutral GB2 density and its two risk-adjusted densities on March
21, 1997 for midquotes.

0.005

0.004

Density

0.003

0.002

0.001

0
3500

4000

4500

5000

Index level at expiry

RND

Utility transformed

Recalibrated

42

Figure 3. The risk-neutral lognormal mixture density and its two risk-adjusted
densities on March 21, 1997 for midquotes.

0.005

Density

0.004

0.003

0.002

0.001

0
3500

4000

4500

5000

Index level at expiry

RND

Utility transformed

Recalibrated

43

Figure 4. Cumulative distributions for cumulative probabilities obtained from GB2

RNDs and two sets of risk-adjusted densities.

0.8

C(u)

0.6

0.4

0.2

0
0

0.2

0.4

0.6

0.8

u
RND

Utility transformed

Recalibrated

Uniform

44

Figure 5. Cumulative distributions for cumulative probabilities obtained from

historical densities.

0.8

C(u)

0.6

0.4

0.2

0
0

0.2

0.4

0.6
u

0.8

45

Figure 6. Empirical pricing kernel, averaged across all expiry months.

GeoMean (Q/P)

2.5

1.5

0.5

0
0.9

0.95

1.05

x/F
GB2/Historical

MixLn/Historical

1.1

46

Figure 7. Risk aversion and relative risk aversion from the geometric means of the
empirical pricing kernels.

25

20

15

10

-5
0.9

0.95

1.05

x/F
RA (GB2)

RRA (GB2)

RA (MixLn)

RRA (MixLn)

1.1