Monte Carlo analysis of methods for extracting risk‐neutral densities with affine jump diffusions

Abstract

This article compares several widely used and recently developed methods to extract risk‐neutral densities (RNDs) from option prices in terms of estimation accuracy. It shows that the positive convolution approximation method consistently yields the most accurate RND estimates, and is insensitive to the discreteness of option prices. RND methods are less likely to produce accurate RND estimates when the underlying process incorporates jumps and when estimations are performed on sparse data, especially for short time‐to‐maturities, though sensitivity to the discreteness of the data differs across different methods.