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Results tagged with risk-neutral-measure
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A risk-neutral measure is a probability measure that yields an expected present value (discounted at the risk-free rate) which is equal to the current market price. The risk-neutral measure is also called an equivalent martingale measure.
7
votes
Is "risk-neutral probability" a misnomer?
Originally "risk-neutral" is a term from economics describing the attitude of investors towards risk: if they are risk-neutral they only factor in the expected value of a decision and not the level of …
- 27.7k
1
vote
Why the Black-Scholes formula can be used in the real world?
Because BS is about derivatives and not about the underlying. In a way if you priced derivatives with real world measures (all else being equal) you would double count risk preferences because these a …
- 27.7k
8
votes
Accepted
When to use the real world drift and when the risk neutral one for a Monte-Carlo simulation?
In general these are the two basic approaches to QuantFinance:
Sell side (market maker, risk neutral): You use risk-neutral probabilities ("$\mathbb{Q}$") e.g. in option pricing (to e.g. calculate yo …
- 27.7k
34
votes
Why Drifts are not in the Black Scholes Formula
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 situ …
- 27.7k
6
votes
How to estimate real-world probabilities
This is indeed one of the most difficult tasks to do (if not next to impossible).
I would say the standard reference is the following:
Expected Returns: An Investor's Guide to Harvesting Market Reward …
- 27.7k
10
votes
Accepted
Black-Scholes and Fundamentals
I think you are interpreting too much into the matter. The $-\frac12\sigma^2$ is just a correction term that comes from Jensen's inequality.
You need this when switching from supposedly symmetric ret …
- 27.7k