Applications of Bayes’ Theorem in Finance
https://www.thestreet.com/personal-finance/education/what-is-bayes-theorem-14797035
The article discusses the applications of Bayes’ Theorem in the field of finance. In particular, the article describes multiple ways in which companies will consider estimated probabilities when evaluating opportunities, rather than using face value numbers. For example, interest rates are critical towards deciding how much money a company can invest and/or borrow. A slight change can drastically change the course of profits. Thus, making decisions based on the current interest rate is considered naive; as a result, companies will estimate relevant probabilities and use Bayes’ Theorem to calculate an expected value which is most likely more robust to market changes. Another example derives from when companies decide on lending credit. A borrower’s history can be used to estimate whether the borrower is worth extending credit for. Specifically, companies can calculate the conditional probability that a borrower is trustworthy based on their history using Bayes’ Theorem.
As taught in class, Bayes’ Theorem provides the foundation for a concrete model on probability that can be extended to multiple fields. As seen above, everyday transactions, and even complex ones that occur more rarely used in finance can be improved upon when considering this rule. Moreover, complex cascades involved in finance can also be modeled similarly by this theorem using what was discussed above as well as information cascades which were shown in class. Truly, the applications of Bayes’ Theorem are everywhere.