Real-World and Risk-Neutral Probabilities in the Regulation on the Transparency of Structured Products

ESMA Working Paper No. 1, 2015

CONSOB Working Papers No. 74

30 Pages Posted: 17 Oct 2013 Last revised: 1 Jul 2016

See all articles by Luca Giordano

Luca Giordano

IOSCO (International Organization of Securities Commissions); CONSOB (Commissione Nazionale per le Società e la Borsa)

Giovanni Siciliano

CONSOB (Commissione Nazionale per le Società e la Borsa)

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2013

Abstract

La versione italiana di questo documento è disponibile al seguente link: http://ssrn.com/abstract=2319271

The price of derivatives (and hence of structured products) can be calculated as the discounted value of expected future payoffs, assuming standard hypotheses on frictionless and complete markets and on the type of stochastic processes for the price of the underlying. However, the probabilities used in the pricing process do not represent “real” probabilities of future events, because they are based on the assumption that market participants are risk-neutral. This paper reviews the relevant mathematical finance literature, and clarifies that the risk-neutrality hypothesis is acceptable for pricing, but not to forecast the future value of an asset. Therefore, we argue that regulatory initiatives that mandate intermediaries to give retail investors information on the probability that, at a future date, the value of a derivative will be higher or lower than a given threshold (so-called “probability scenarios”) should explicitly reference probabilities that take into account the risk premium (so-called “real-world” probabilities). We also argue that, though probability scenarios may look appealing to foster investor protection, their practical implementation, if based on the right economic approach, raises significant regulatory and enforcement problems.

Keywords: derivatives, structured products, risk-neutral pricing, probability scenarios

JEL Classification: C02, C51, C58, G12, G17, G33

Suggested Citation

Giordano, Luca and Siciliano, Giovanni, Real-World and Risk-Neutral Probabilities in the Regulation on the Transparency of Structured Products (August 1, 2013). ESMA Working Paper No. 1, 2015, CONSOB Working Papers No. 74, Available at SSRN: https://ssrn.com/abstract=2341063 or http://dx.doi.org/10.2139/ssrn.2341063

Luca Giordano (Contact Author)

IOSCO (International Organization of Securities Commissions) ( email )

Calle Oquendo, 12
Madrid, Madrid 28006
Spain

CONSOB (Commissione Nazionale per le Società e la Borsa) ( email )

Roma 00198
Italy

Giovanni Siciliano

CONSOB (Commissione Nazionale per le Società e la Borsa) ( email )

Via G.B. Martini, 3
Roma, 00199
Italy
+39-06-8477544 (Phone)
+39-06-8477612 (Fax)

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