Options in markets with unknown dynamics

DOI10.1515/WWFAA-2018-0004MaRDI QIDQ2331247zbMATH OpenOpenAlexWikidataFDO

Authors Hanno Gottschalk, Elpida Nizami, Marius Schubert

Publication date 25 October 2019

Published in Waves, Wavelets and Fractals. Advanced Analysis (Search for Journal in Brave)

Copyright license Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International

Full work available at URL https://arxiv.org/abs/1602.04848

zbMATH Keywords

Bayesian arbitrage free option pricingBayesian consistencyself similarity

Mathematics Subject Classification ID

Martingales with continuous parameter (60G44) Processes with independent increments; Lévy processes (60G51) Applications of statistics to actuarial sciences and financial mathematics (62P05) Microeconomic theory (price theory and economic markets) (91B24) Derivative securities (option pricing, hedging, etc.) (91G20)

Abstract: We consider arbitrage free valuation of European options in Black-Scholes and Merton markets, where the general structure of the market is known, however the specific parameters are not known. In order to reflect this subjective uncertainty of a market participant, we follow a Bayesian approach to option pricing. Here we use historic discrete or continuous observations of the market to set up posterior distributions for the future market. Given a subjective physical measure for the market dynamics, we derive the existence of arbitrage free pricing rules by constructing subjective option pricing measures. The non-uniqueness of such measures can be proven using the freedom of choice of prior distributions. The subjective market measure thus turns out to model an incomplete market. In addition, for the Black-Scholes market we prove that in the high frequency limit (or the long time limit) of observations, Bayesian option prices converge to the standard BS-Option price with the true volatility. In contrast to this, in the Merton market with normally distributed jumps Bayesian prices do not converge to standard Merton prices with the true parameters, as only a finite number of jump events can be observed in finite time. However, we prove that this convergence holds true in the limit of long observation times.

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Cited in

(6)

• Markets that don't replicate any option.
• Limits of Bayesian decision related quantities of binomial asset price models
• Option prices as information predictor via sequential Bayesian statistics
• Option Pricing in the Presence of Uncertainty
• UNCERTAINTY IN PRICING TRADABLE OPTIONS
• Option market making under inventory risk

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