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Risk-neutral Valuation: A Gentle Introduction (1)


Joseph Tham


Duke University - Duke Center for International Development in the Sanford School of Public Policy

November 2001



Abstract:     
Risk-neutral valuation is simple, elegant and central in option pricing theory. However, in teaching risk-neutral valuation, it is not easy to explain the concept of 'risk-neutral' probabilities. Beginners who are new to risk-neutral valuation always have lingering doubts about the validity of the probabilities. What do the probabilities really mean? Are they real or fictional? Where do they come from? What is the relationship between the risk-neutral probabilities and the actual probabilities? Does it mean that all investors are risk-neutral? When is it appropriate to use the risk-free rate as the discount rate?

From a pedagogical point of view, in the beginning it is best to avoid the use of probabilities because probabilities can be a barrier to understanding. Instead, it is far preferable to introduce the idea of state prices and then show that the approach with risk-neutral probabilities is equivalent to the use of state prices.

In this teaching note, we use simple one-period examples to explain the intuitive ideas behind risk-neutral valuation. It is a gentle introduction to risk-neutral valuation, with a minimum requirement of mathematics and prior knowledge. We will provide the motivation and the rationale for calculating state prices and we will show that the risk-neutral approach is simply another way of looking at the issue of state prices.

Number of Pages in PDF File: 55

Keywords: Risk-neutral valuation

JEL Classification: D61, G31, H43

working papers series





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Date posted: November 12, 2001  

Suggested Citation

Tham, Joseph, Risk-neutral Valuation: A Gentle Introduction (1) (November 2001). Available at SSRN: http://ssrn.com/abstract=290044 or http://dx.doi.org/10.2139/ssrn.290044

Contact Information

Joseph Tham (Contact Author)
Duke University - Duke Center for International Development in the Sanford School of Public Policy ( email )
Box 90312
302, Towerview Dr, Rubenstein Hall, Room 272
Durham, NC 27708
United States
919-613-9234 (Phone)
919-681-0831 (Fax)
HOME PAGE: http://fds.duke.edu/db/Sanford/faculty/thamjx
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