A Simple Pragmatic Justification for Risk-Neutral Option Pricing

12 Pages Posted: 2 Nov 2007

See all articles by Tom Arnold

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Date Written: October 26, 2007

Abstract

We give a simple pragmatic justification for risk neutral pricing that can be presented in a classroom without the explicit use of any advanced mathematics. We do this by exploiting a generalized binomial option pricing model developed by Arnold and Crack [2000]. This model allows for a spreadsheet demonstration that the price of an option is immune to choice of discount rate. We show that the pragmatic choice is to price the option as if investors are risk neutral. Our argument also allows us to step into some properties of martingale measure with very little preparation.

Keywords: Risk-Neutral Option Pricing, Binomial Option Pricing, Risk-Adjusted Option Pricing, Physical Probability Measure, RA-BT

JEL Classification: A20, G10, G12, G13

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon, A Simple Pragmatic Justification for Risk-Neutral Option Pricing (October 26, 2007). Available at SSRN: https://ssrn.com/abstract=1026133 or http://dx.doi.org/10.2139/ssrn.1026133

Thomas M. Arnold

University of Richmond - E. Claiborne Robins School of Business ( email )

1 Gateway Drive
Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack (Contact Author)

University of Otago - Department of Accountancy and Finance ( email )

Dunedin
New Zealand

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