Risk-Neutral Probabilities Explained
27 Pages Posted: 27 Apr 2009 Last revised: 20 Oct 2010
Date Written: October 10, 2010
All too often, the concept of risk-neutral probabilities in mathematical finance is poorly explained, and misleading statements are made. The aim of this paper is to provide an intuitive understanding of risk-neutral probabilities, and to explain in an easily accessible manner how they can be used for arbitrage-free asset pricing. The paper is meant as a stepping-stone to further reading for the beginning graduate student in finance.
Keywords: derivative, redundant asset, arbitrage, arbitrage-free pricing, risk-neutral, risk-neutral probability, martingale, martingale measure, Girsanov, geometric Brownian motion, Gisiger, Nicolas Gisiger
JEL Classification: A20, A22, A23, G12, G13
Suggested Citation: Suggested Citation