Distributions Implied by Exchange Traded Options: A Ghost’s Smile?

Abstract

A new and easily applicable method for estimating risk neutral distributions (RND) implied by American futures options is proposed. It amounts to inverting the Barone-Adesi and Whaley method (1987) (BAW method) to get the BAW implied volatility smile. Extensive empirical tests show that the BAW smile is equivalent to the volatility smile implied by corresponding European options. Therefore, the procedure leads to a legitimate RND estimation method. Further, the investigation of the currency options traded on the Chicago Mercantile Exchange and OTC markets in parallel provides us with insights on the structure and interaction of the two markets. Unequally distributed liquidity in the OTC market seems to lead to price distortions and an ensuing interesting ‘ghost-like ’ shape of the RND density implied by CME options. Finally, using the empirical results, we propose a parsimonious generalisation of the existing methods for estimating volatility smiles from OTC options. A single free parameter signi…cantly improves the …t