Question

What are the advantages of using the Bayesian approach in Finance?

Answer 1

Answer

introduction of Bayesian approach in Finance

Bayesian methods provide a natural framework for addressing central issues in finance. In particular, they allow investors to assess return predictability, estimation and model risk, for- mulated predictive densities for variances, covariances and betas.

Advantages of using the Bayesian approach in Finance

1. You don't have to know a lot about probability theory to use a Bayesian probability model (or) approach for financial forecasting. The Bayesian method can help you refine probability estimates using an intuitive process.
2. The way that Bayesian probability is used in corporate America is dependent on a degree of belief rather than historical frequencies of identical or similar events. The model is versatile, though. You can incorporate your beliefs based on frequency into the model.
3. The particular formula from Bayesian probability (or) approach we are going to use is called Bayes' Theorem, sometimes called Bayes' formula or Bayes' rule. This rule is most often used to calculate what is called the posterior probability. The posterior probability is the conditional probability of a future uncertain event that is based upon relevant evidence relating to it historically.
4. In other words, if you gain new information or evidence and you need to update the probability of an event occurring, you can use Bayes' Theorem to estimate this new probability.
5. Many people put great emphasis on the estimates and simplified probabilities given by experts in their field. This also gives us the ability to confidently produce new estimates for new and more complicated questions introduced by the inevitable roadblocks in financial forecasting.
6. Changing interest rates can greatly affect the value of particular assets. The changing value of assets can therefore greatly affect the value of particular profitability and efficiency ratios used to proxy a company's performance. Estimated probabilities are widely found relating to systematic changes in interest rates and thus can be used effectively in Bayes' Theorem.
7. We can also apply the process to a company's net income stream. Lawsuits, changes in the prices of raw materials, and many other things can influence a company's net income.
8. By using probability estimates relating to these factors, we can apply Bayes' Theorem to figure out what is important to us. Once we find the deduced probabilities that we are looking for, it is a simple application of mathematical expectancy and result forecasting to quantify the financial probabilities.
9. Using a myriad of related probabilities, we can deduce the answer to rather complex questions with one simple formula. These methods are well accepted and time-tested. Their use in financial modeling can be helpful if applied properly.

10. An Example

    Let's say we want to know how a change in interest rates would affect the value of a stock market index.

    A vast trove of historical data is available for all the major stock market indexes, so you should have no problem finding the outcomes for these events. For our example, we will use the data below to find out how a stock market index will react to a rise in interest rates.

    

    Here:

    P(SI) = the probability of the stock index increasing
    P(SD) = the probability of the stock index decreasing
    P(ID) = the probability of interest rates decreasing
    P(II) = the probability of interest rates increasing

Conclusion

Above are the Advantages of using the Bayesian approach in Finance