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Among other things, Bloomberg FXFM function allows you to check risk neutral probabilities for currencies. For instance, you can check the probability of the euro depreciating 5% vs the dollar in 6 months. However, these are risk neutral probabilities, not real probabilities. From my understanding of financial theory, going from risk neutral to real probabilities is an extremely messy process (for instance, you have to make assumptions about the pricing kernel etc...). So what is the point of knowing these figures? Is my notion that risk neutral quantities are not useful wrong (for instance, also the VIX is based on risk-neutral volatility)? Do practitioners in the end interpret them as if they are physical probabilities in a mathematical sense?

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Risk neutral probabilities are immensely useful. As you might know, they are the building blocks used to calculate derivatives prices across most asset classes. An entire industry is based on that.

From a more basic perspective, knowing the risk neutral probability tells you what the market implied probability is. The point is, you can compare that with your own perception of the probability. If those numbers are materially different, you have a trading opportunity.

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  • $\begingroup$ I should have been clearer in stating "useful outside the field of derivative pricing", but thanks a lot for the answer. Indeed, I wanted to check if it was more correct to compare my subjective probabilities (what I think it will happen) vs risk neutral probabilities instead that with physical probabilities, recovered in a way or the other. $\endgroup$
    – Peter
    Apr 23, 2023 at 13:35

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