Risk-Neutral Probabilities
Candlefocus EditorRisk-neutral probabilities attempt to isolate the effect of uncertainty on the value of an asset or financial holding. By adjusting for risk, these probabilities can give a more accurate representation of the expected asset value.
Calculating risk-neutral probabilities requires making an assumption that there is no arbitrage. Arbitrage is the process of taking advantage of price discrepancies in order to make a riskless profit. If an arbitrage opportunity exists, then the risk-neutral probabilities will be inaccurate because the expected return won't accurately reflect the associated risk level.
The concept of risk-neutral probabilities is often used in pricing derivatives. Derivatives are financial instruments whose value is based on an underlying asset. Risk-neutral probabilities are used to price these instruments because they allow for taking into account the possibility of different outcomes and associated risks.
In conclusion, risk-neutral probabilities are used to calculate the expected asset value of financial instruments. Risk-neutral probabilities are adjusted for risk, meaning that the associated expected return reflects the associated riskiness of the asset. In order to accurately calculate risk-neutral probabilities, the assumption that there is no arbitrage must be made. And finally, the concept of risk-neutral probabilities is often used in pricing derivatives.