Encyclopedia of Financial Models, 3 Volume Set

Basic Principles of Bayesian Analysis

BILIANA S. GÜNER, PhD

Assistant Professor of Statistics and Econometrics, Ozyegin University, Turkey

SVETLOZAR T. RACHEV, PhD, Dr SCI

Frey Family Foundation Chair Professor, Department of Applied Mathematics and Statistics, Stony Brook University, and Chief Scientist, FinAnalytica

JOHN S. J. HSU, PhD

Professor of Statistics and Applied Probability, University of California, Santa Barbara

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: One of the basic mechanisms of learning is assimilating the information arriving from the external environment and then updating the existing knowledge base with that information. This mechanism lies at the heart of the Bayesian framework. A Bayesian decision maker learns by revising beliefs in light of the new data that become available. From the Bayesian point of view, probabilities are interpreted as degrees of belief. Therefore, the Bayesian learning process consists of revising probabilities. Contrast this with the way probability is interpreted in the classical (frequentist) statistical theory—as the relative frequency of occurrence of an event in the limit, as the number of observations goes to infinity. Bayes’ theorem provides the formal means of putting that mechanism into action; it is a simple expression combining the knowledge about the distribution of the model parameters and the information about the parameters contained in the data.

Quantitative financial ...