THE ENTROPY THEORY OF BOND OPTION PRICING

Les Gulko ()
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Les Gulko: Paloma Partners, Two American Lane, Greenwich, CT 06836-2571, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2002, vol. 05, issue 04, 355-383

Abstract: An informationally efficient price keeps investors as a group in the state of maximum uncertainty about the next price change. The Entropy Pricing Theory (EPT) captures this intuition and suggests that, in informationally efficient markets, perfectly uncertain market beliefs must prevail. When the entropy functional is used to index collective market uncertainty, then the entropy-maximizing consensus beliefs must prevail. The EPT resolves the ambiguity of arbitrage-free valuation in incomplete markets. The EPT produces a new bond option model that is similar to Black–Scholes' with the lognormal distribution replaced by a beta distribution. Unlike alternative models, the beta model is valid for arbitrary term structure dynamics and for arbitrary credit risk of the underlying bonds. Option replication and hedging under the beta model accounts for random changes in the underlying bond price, price volatility and short-term interest rates.

Keywords: Bond options; incomplete markets; entropy (search for similar items in EconPapers)
Date: 2002
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Citations: View citations in EconPapers (7)

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DOI: 10.1142/S021902490200147X

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