A Simple Pragmatic Justification for Risk-Neutral Option Pricing
12 Pages Posted: 2 Nov 2007
Date Written: October 26, 2007
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 . 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: Suggested Citation