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Volume 31 Number 2 Decembe r 2006 |
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Bayesian Prediction, Entropy, and Option Pricing |
| F. Douglas Foster |
| Charles H. Whiteman |
Abstract |
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This paper studies the performance of the Foster-Whiteman (1999) procedure
for using a Bayesian predictive distribution for the future price of an asset
to compute the price of a European option on that asset. A technical
contribution of the paper is the description of a sequential importance
sampling procedure for implementing an informative prior that reflects and
rewards past option-pricing success. The risk-neutralization of the
predictive distribution is accomplished by Stutzer's (1996) constrained
KLIC-minimizing change of measure. The procedure is used in weekly pricing of
July and November options on soybeans on the Chicago Board of Trade from
1993-1997, and produces option prices that mimic market prices much more
closely than those of the Black model or those produced by risk-neutralizing
a nonparametric predictive.
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| Download this article. |
Keywords |
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BAYESIAN PREDICTION; ENTROPY; OPTION PRICING;
COMMODITIES
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Contact DetailsF. Douglas Foster,Finance, University of New South Wales, Sydney, NSW 2052 E-mail: fd.foster@unsw.edu.au Charles H. Whiteman, Tippie College of Business, The University of Iowa |
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