The risk-neutral

density
Vanilla European Options
• The
  value for a European call option is:

• The value of a European put option is:

• Breeden and Litzenberger (1978) showed that the risk-neutral probability is

derived by:
Risk-neutral density
• Therefore, the series of call option price fully reveals the risk-neutral
probability distribution.

• Since strike prices are not continuously priced, implied volatilities (or
option prices) need to be imputed for the missing ones to give a full
continuous probability density function (pdf).
• A number of methods have been proposed for doing this ranging from linear
interpolation, to splines, to weighted distribution methods.

• This density is also expected to vary by maturity of options.

Risk-neutral density theory
• 
• The absence of arbitrage is required for a risk-neutral measure to exist.

• Recall that the risk-neutral density is the probability measure such that:

• Therefore, reduces the weights of up move probabilities and increases the weights of down move probabilities
relative to the (unobservable) true probability measure .

• The Radon-Nikodym derivative allows switching between probability measures:

• Where is given by Girsanov’s Theorem.

Risk-neutral density theory
• The risk-neutral measure gives the “fair” price for the delivery of an
asset at some future date.

• Therefore, the risk-neutral pdf gives us a distribution that we can use

to calculate the fair value for delivery of some investment asset in the
future.
• Consider a hypothetical forward stock price.
• This “fair” value does not incorporate the risk-premium, however. It only
gives the fair delivery price that would prevent a risk-free arbitrage
opportunity.
Recovery
•  The difficulty, which still hasn’t been figured out in a satisfactory
fashion, is how to recover the true probability measure .

• We know , but which choice do we use for the Radon-Nikodym

derivative ?
• Do we back out by assuming that the true probability distribution is constant
and compare that to the implied distribution?
• Do we assume a model for ?