Direct semi-parametric estimation of the state price density implied in option prices

Abstract: We present a model for direct semi-parametric estimation of the State Price Density (SPD) implied in quoted option prices. We treat the observed prices as expected values of possible pay-offs at maturity, weighted by the unknown probability density function. We model the logarithm of the latter as a smooth function while matching the expected values of the potential pay-offs with the observed prices. This leads to a special case of the penalized composite link model. Our estimates do not rely on any parametric assumption on the underlying asset price dynamics and are consistent with no-arbitrage conditions. The model shows excellent performance in simulations and in application to real data.