Do option markets correctly price the probabilities of movement of the underlying asset?

We answer this question by comparing te risk-neutral density estimated in c omplete markets from cross-section of S&P 500 option prices to the risk-neu tral density inferred from the time series density of the S&P 500 index. If investors are risk-averse, the latter density is different from the actual density that could be inferred from the time series of S&P 500 returns. Na turally, the observed asset returns do not follow the risk-neutral dynamics , which are therefore not directly observable. In contrast to the existing literature, we avoid making any assumptions on investors' preferences, by c omparing two risk-adjusted densities, rather than a risk-adjusted density f rom option prices to an unadjusted density from index returns. Our only mai ntained hypothesis is a one-factor structure for the S&P 500 returns. We pr opose a new method, based on an empirical Girsanov's change of measure, to identify the risk-neutral density from the observed unadjusted index return s. We design four different tests of the null hypothesis that the S&P 500 o ptions are efficiently priced given the S&P 500 index dynamics, and reject it. By adding a jump component to the index dynamics, we are able to partly reconcile the differences between the index and option-implied risk-neutra l densities, and propose a peso-problem interpretation of this evidence. (C ) 2001 Elsevier Science S.A. All rights reserved.