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Neutral Density
by Fabrice Douglas Rouah
www.FRouah.com
www.Volopta.com
In this Note we show that a portfolio based on a buttery spread can approximate the risk neutral density (RND), and we establish the result that the
second derivative of the call price with respect to strike is the RND.
The Portfolio
A buttery spread is constructed with three call options, each with identical
maturity T , but with dierent strikes. In particular, the buttery spread is
Long one option at strike K
dK;
C(K
dK)
Its
(1)
where C(K) = C(St ; K; T ) is the time-t price of a call with strike K and maturity T:
dK; K + dK]
(3)
Kj
T
1ST 2[K dK;K+dK] . The behavior
In other words, V (ST ; K; T; dK) = dK+jS
dK 2
of the terminal payo V (ST ; K; T; dK) as dK shrinks is illustrated in the gure
below, for three values of dK. It appears that V (ST ; K; T; dK) approaches the
Dirac delta function. This will be shown in the next few lines.
10
9
dK = 0.1
dK = 0.2
dK = 0.5
Terminal Value
7
6
5
4
3
2
1
0
99
99.2
99.4
99.6
99.8
100
100.2
Strike Price (K)
100.4
100.6
100.8
101
Consider the limit of the payo as the increment dK approaches zero. From
Equation (2) we can see that this limit is
lim V (ST ; K; T; dK) =
dK!0
1
0
if ST = K
if ST 6= K:
(4)
1
1
The area under V (ST ; K; T; dK) is 21 dK
dK + 12 dK dK
= 1 for all values of dK:
Hence, we can establish a stronger result than Equation (4) that the limit of
the terminal payo of the portfolio is the Dirac delta function
dK!0
K):
Consider again the time-t value in Equation (1), which can be written as the
expected payo under the risk neutral measure Q, discounted to time t
V (St ; K; T; dK) = P (t; T )EtQ [V (ST ; K; T; dK)]
dK!0
= P (t; T )EtQ
dK!0
(5)
K)]
K)fST (K)dK
where fST denotes the risk neutral density of the terminal stock price ST .
Hence, as the increment dK vanishes, the portfolio approaches the risk neutral density, evaluated at K and discounted back to time t.
V (St ; K; T; dK) =
C(K) C(K+dK)
dK
dK
dK!0
@2C
:
@K 2
(6)
@2C
;
@K 2
the well-known result that the discounted risk neutral density is the second
derivative of the call price with respect to strike.
As a sidebar, the buttery spread can also be used to construct a portfolio whose
terminal value converges to an Arrow-Debreu security. Consider an alternate
1
1 2
portfolio, comprised of dK
units of a buttery spread instead of dK
units.
This portfolio has the terminal payo
W (St ; K; T; dK) =
dK + jST
dK
Kj
1ST 2[K
dK;K+dK]
dK!0
1
0
if ST = K
if ST =
6 K:
1
dK = 0.1
dK = 0.2
dK = 0.5
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
99
99.2
99.4
99.6
99.8
100
100.2
100.4
100.6
100.8
101