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

The paper proposes a new and readily applicable method for estimating risk-neutral distributions (RND) implied by American futures options. It amounts to inverting the Barone-Adesi and Whaley (BAW) method to get a BAW-implied volatility „smile.“ Extensive empirical tests show that the BAW smile is equivalent to the volatility smile as implied by corresponding European options. Therefore, the procedure leads to a legitimate RND-estimation method. Further, an investigation of currency options as traded both on the Chicago Mercantile Exchange (CME) and on over-the-counter (OTC) markets provides insights into the structure and interaction between the markets. Unequally distributed liquidity on OTC markets seem to lead to price distortions and an ensuing „ghost-like“ shape of RND as implied by CME options. Finally, using empirical results, the author proposes a parsimonious generalization of the existing methods for estimating volatility smiles based on OTC options. A single, free parameter significantly improves the regression.