Estimation of security excess returns from derivative prices and testing for risk-neutral pricing

This paper develops an econometric framework for ~i! estimating excess returns of the security process from high frequency derivative prices, ~ii! testing for risk neutral pricing, and ~iii! measuring premiums outside the no-arbitrage pricing model+ The estimator is constructed by applying quasi-likelihood and Feynman–Kac theory to the risk neutral contingent claims pricing model to generate the optimal orthogonality restriction+ The strong consistency and asymptotic normality of the estimator are established in the context of a nonstationary underlying state process+ These results further imply that the estimator is robust to distributional assumptions on the underlying asset process+ The proposed approach is applicable to any arbitrary derivative security, does not require estimation of the risk neutral probability measure, and has application to spot rate bond pricing models+ A controlled diagnostic study based on generating the S&P500 index and calls verifies the ability of the estimators to correctly estimate security excess returns and test for risk neutral pricing+ The estimator is invariant to call strikes,and larger samples constructed by cycling over shorter maturity options can be used to reduce its variance