New answers tagged risk-neutral-measure
2
Being on the sell side and selling options you can intuitively think of it like this:
An option is like any other product that is being produced out of ingredients and because of the competitive situation of the producer this is done by the cheapest possible production process.
The ingredients are in a simple (Black Scholes) setting a stock and and a risk ...
2
$$dS / S = \mu dt + \sigma dW \\
\\ dS / S -r dt= \mu dt - rdt + \sigma dW \\
\\ dS / S -r dt= [\frac{(\mu - r)}{\sigma}dt + dW]\sigma \\$$
Then, Girsanov tells us that, as long as the risk premium is bounded from below, we can write
$[\frac{(\mu - r)}{\sigma}dt + dW]\sigma$ as $\sigma d\tilde{W}$ where $\tilde{W}$ is simply another brownian motion with ...
9
Here couple pointers that may make it clearer:
Drift can be replaced by the risk-free rate through a mathematical construct called risk-neutral probability pricing.
Why can we get away with that without introducing errors? The reason lies in the ability to setup a hedge portfolio, thus the market will not compensate us for the drift above and beyond the ...
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