Testing the stability of implied probability density functions

This paper examines the absolute and relative robustness of two of the most common methods for estimating implied probability density functions (PDFs) - the double-lognormal approximating function and the smoothed implied volatility smile methods using short sterling futures options and the FTSE 100 index options. The changes resulting from randomly perturbing quoted prices by no more than a half tick provide a lower bound on the confidence intervals of the summary statistics derived from the estimated PDFs. Our tests show that the smoothed implied volatility smile method dominates the double lognormal as a technique for estimating implied PDFs. (C) 2002 Elsevier Science B.V. All rights reserved.