BAYESIAN INFERENCE, PRIOR INFORMATION ON VOLATILITY, AND OPTION PRICING: A MAXIMUM ENTROPY APPROACH

Abstract

This paper develops a Bayesian model for pricing derivative securities with prior information on volatility. Prior information is given in terms of expected values of levels and rates of precision: the inverse of variance. We provide several approximate formulas, for valuing European call options, on the basis of asymptotic and polynomial approximations of Bessel functions.