Bayesian parameter inference for models of the Black and Scholes type

Henryk Gzyl (), Enrique ter Horst and Samuel Malone

Applied Stochastic Models in Business and Industry, 2008, vol. 24, issue 6, 507-524

Abstract: In this paper, we describe a general method for constructing the posterior distribution of the mean and volatility of the return of an asset satisfying dS=SdX for some simple models of X. Our framework takes as inputs the prior distributions of the parameters of the stochastic process followed by the underlying, as well as the likelihood function implied by the observed price history for the underlying. As an application of our framework, we compute the value at risk (VaR) and conditional VaR (CVaR) measures for the changes in the price of an option implied by the posterior distribution of the volatility of the underlying. The implied VaR and CVaR are more conservative than their classical counterpart, since it takes into account the estimation risk that arises due to parameter uncertainty. Copyright © 2008 John Wiley & Sons, Ltd.

Date: 2008
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https://doi.org/10.1002/asmb.709

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Persistent link: https://EconPapers.repec.org/RePEc:wly:apsmbi:v:24:y:2008:i:6:p:507-524

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