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Advances in Decision SciencesVolume 2010 2010, Article ID 598103, 15 pages

Research ArticleDivision of Mathematical Statistic, Centre for Mathematical Sciences, Lund University, P.O. Box 118, 22100 Lund, Sweden

Received 7 September 2009; Accepted 13 February 2010

Academic Editor: Henry Schellhorn

Copyright © 2010 Erik Lindström. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.


Financial markets are complex processes where investors interactto set prices. We present a framework for option valuation under imperfectinformation, taking risk neutral parameter uncertainty into account. Theframework is a direct generalization of the existing valuation methodology. Many investors base their decisions on mathematical models that have beencalibrated to market prices. We argue that the calibration process introducesa source of uncertainty that needs to be taken into account. The modelsand parameters used may differ to such extent that one investor may find anoption underpriced; whereas another investor may find the very same optionoverpriced. This problem is not taken into account by any of the standardmodels. The paper is concluded by presenting simulations and an empirical studyon FX options, where we demonstrate improved predictive performance in sample and out of sample using this framework.

Author: Erik Lindström



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