Abstract
It is common in financial markets for market makers to offer prices on derivative instruments even though they are uncertain about the underlying asset’s value. This paper studies the mathematical problem that arises as a result. Derivatives are priced in the risk-neutral framework, so as the market maker acquires more information about the underlying asset, the change of measure for transition to the risk-neutral framework (the pricing kernel) evolves. This evolution takes a precise form when the market maker is Bayesian. It is shown that Bayesian updates can be characterized as additional informational drift in the underlying asset’s stochastic process. With Bayesian updates, the change of measure needed for pricing derivatives is two-fold: the first change is from the prior probability measure to the posterior probability measure, and the second change is from the posterior probability measure to the risk-neutral measure. The relation between the regular pricing kernel and the pricing kernel under this two-fold change of measure is characterized.
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