Investors and researchers have long used the market prices of stock options to estimate the potential range and likelihood of future stock returns of an individual firm, or the risk neutral distribution (RND). When this method is applied to an individual firm, however, it only captures the middle portion of a RND, or the most probable stock return values. By not modeling a left tail of the distribution, these RNDs may not accurately capture the downside risk that investors face.
Samuel Rosen and his co-authors propose a new method to estimate firm-specific risk neutral distributions (RND) using data from both stock options and credit default swaps (CDS). This new approach pins down the left tail of the distribution curve, improving the estimation of the overall RND. Interested parties can find the code to implement the new method on Rosen’s website and other implementation details in the paper itself.