How Useful are Implied Distributions? Evidence from Stock-Index Options

SPRING 2000 THE JOURNAL OF DERIVATIVES 1 Option prices can reveal implied (risk-neutral) distributions, but it is not clear whether these are useful for forecasting or hedging or for revealing the current sentiment of investors. The authors estimate the implied distribution for stock index options in London as a mixture of two lognormals over the period 1987-1997 and find that this method is much better than the one-lognormal approach at fitting observed option prices. It is also somewhat better at predicting and hedging out-of-sample prices, but an ad hoc model based on market practice performs even better.