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The Maximum Entropy Distribution of an Asset Inferred from Option Prices

Published online by Cambridge University Press:  06 April 2009

Peter W. Buchen  and
Michael Kelly
Peter W. Buchen
Affiliation:
School of Mathematics and Statistics, University of Sydney, Australia
Michael Kelly
Affiliation:
Department of Mathematical Sciences, University of Western Sydney, Macarthur, Australia
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Abstract

This paper describes the application of the Principle of Maximum Entropy to the estimation of the distribution of an underlying asset from a set of option prices. The resulting distribution is least committal with respect to unknown or missing information and is, hence, the least prejudiced. The maximum entropy distribution is the only information about the asset that can be inferred from the price data alone. An extension to the Principle of Minimum Cross-Entropy allows the inclusion of prior knowledge of the asset distribution. We show that the maximum entropy distribution is able to accurately fit a known density, given simulated option prices at different strikes.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 31 , Issue 1 , March 1996 , pp. 143 - 159
Copyright
Copyright © School of Business Administration, University of Washington 1996

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