Downside Risk Neutral Probabilities
15 Pages Posted: 19 Feb 2015 Last revised: 26 Sep 2018
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Downside Risk Neutral Probabilities
Downside Risk Neutral Probabilities
Date Written: September 2018
Abstract
We show that there exists a probability measure under which the CAPM formula for expected returns holds for general utility functions and probability distributions. This probability measure, the ``downside risk neutral'' measure, is adjusted to incorporate the effects of downside risk and higher degree risks. It thus belongs to the same family as the risk neutral measure, which is also a risk-adjusted measure. Using risk preference theory, we interpret this change in probability measure in terms of risk substitution.
Keywords: downside risk, prudence, risk aversion, risk neutral probabilities, risk substitution
JEL Classification: D81, G12
Suggested Citation: Suggested Citation