The epistemology of modern finance

Abstract

Modern finance is a social science where the complexity of mathematical models compares to that of physics. The aim of this paper is to provide a conceptual framework for the interpretation of mathematical models in finance, in order to determine the epistemological standards according to which financial theory must be assessed. The analysis enlightens the contrast between highly objective results and the radical uncertainty that governs the markets. The main contribution of the paper is to show that the reasons why finance models are relative and non-causal are deeply rooted in the nature of finance theory itself. An important consequence is that arbitrage-free model prices are reference prices and indicators of the economical features underlying mathematical models. As such, they can be used to structure and support final pricing and hedging decisions, but not to predict future market prices.

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