Risk-neutral measure

Financial risk modeling

In mathematical finance, a risk-neutral measure (also called an equilibrium measure, or equivalent martingale measure) is a probability measure such that each share price is exactly equal to the discounted expectation of the share price under this measure.This is heavily used in the pricing of financial derivatives due to the fundamental theorem of asset pricing, which implies that in a complete market, a derivative's price is the discounted expected value of the future payoff under the unique risk-neutral measure. Such a measure exists if and only if the market is arbitrage-free. The easiest way to remember what the risk-neutral measure is, or to explain it to a probability generalist who might not know much about finance, is to realize that it is: 1. * The probability measure of a transformed random variable. Typically this transformation is the utility function of the payoff. The risk-neutral measure would be the measure corresponding to an expectation of the payoff with a linear utility. 2. * An implied probability measure, that is one implied from the current observable/posted/traded prices of the relevant instruments. Relevant means those instruments that are causally linked to the events in the probability space under consideration (i.e. underlying prices plus derivatives), and 3. * It is the implied probability measure (solves a kind of inverse problem) that is defined using a linear (risk-neutral) utility in the payoff, assuming some known model for the payoff. This means that you try to find the risk-neutral measure by solving the equation where current prices are the expected present value of the future pay-offs under the risk-neutral measure. The concept of a unique risk-neutral measure is most useful when one imagines making prices across a number of derivatives that would make a unique risk-neutral measure since it implies a kind of consistency in ones hypothetical untraded prices and, theoretically points to arbitrage opportunities in markets where bid/ask prices are visible. It is also worth noting that in most introductory applications in finance, the pay-offs under consideration are deterministic given knowledge of prices at some terminal or future point in time. This is not strictly necessary to make use of these techniques. (Wikipedia).

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Risk-neutral measure

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