--%>

Explain various explanations regarding risk-neutral pricing

Explain various explanations regarding risk-neutral pricing.

E

Expert

Verified

Here are several further explanations of risk-neutral pricing.

Explanation 1: When you hedge correctly within a Black–Scholes world then all risk is removed. If there is no risk after that we must not expect any compensation for risk. We can therefore work in a measure wherein everything grows at the risk-free interest rate.

Explanation 2: When the model for the asset is dS = µSdt + σSdX then the µs cancel within the derivation of such Black–Scholes equation.

Explanation 3: Two measures are equal if they have similar sets of zero probability. Since zero probability sets don’t change, a portfolio is an arbitrage in one measure if and only if this is one under all equivalent measures. Thus a price is non-arbitrageable within the real world if and only if this is non- arbitrageable in the risk-neutral world. There in risk-neutral price is always non-arbitrageable. When everything has a discounted asset price process that is a martingale then there can be no arbitrage. Therefore if we change to a measure in that all the fundamental assets, for illustration the stock and bond, are martingales after discounting, and then explain the option price to be the discounted expectation making this in a martingale also, we have that everything is a martingale within the risk-neutral world. Hence there is no arbitrage in the real world.

Explanation 4: We can synthesize arbitrarily suitably any payoff with similar expiration, if we have calls with a continuous distribution of strikes from zero to infinity. But these calls explain the risk-neutral probability density function for such expiration, and therefore we can interpret the synthesized option in terms of risk-neutral random walks. If such a static replication is possible then this is model independent, we can price complex derivatives in terms of vanillas. (Obviously, the continuous distribution requirement does spoil it argument to some extent.) This must be noted that risk-neutral pricing only works under assumptions of zero transaction costs, continuous hedging and continuous asset paths. Once we move away from such simplifying world we may get that this doesn’t work.

   Related Questions in Financial Management

  • Q : What is volatility in finance What is

    What is volatility in finance?

  • Q : What will happen when a bank gives

    What will happen when a bank gives discount interest on a loan?

  • Q : Empirical studies regarding factors

    Why do you think the empirical studies regarding factors affecting equity returns mainly showed which domestic factors were more significant than international factors, and, secondly, that industrial membership of firm was of little importance in forecasting t

  • Q : Riskiness of portfolios The riskiness

    The riskiness of portfolios should be looked at in a different way than the riskiness of individual assets. Explain.

  • Q : Tabulate advantages of the flexible

    Tabulate the advantages of the flexible exchange rate regime. The advantages of the flexible exchange rate system comprise: (I) automatic attainment of balance of payments equilibrium and (ii) maintenance of national policy autonomy.

  • Q : Explain different forms of market

    Explain different forms of market efficiency.

  • Q : The cost of equity or the cost of debt

    Which is lesser for a particular company: the cost of equity or the cost of debt (ignoring taxes)?  Explain.

  • Q : Calculate the rate of return in terms

    Mr. James K. Silber, an avid international investor, only sold a share of Rhone-Poulenc, a French firm, for FF50. The share was bought for FF42 year ago. Now the exchange rate is FF5.80 per U.S. dollar and was FF6.65 per dollar a year ago. Mr. Silber attained

  • Q : Determine the efficiency of finite

    Determine the efficiency of finite differences?

  • Q : Bidding You are required to submit a

    You are required to submit a bid to supply 200,000,000 widgets per year to the State of Illinois for the next five years. Your company has an idle tract of real estate that cost $1,500,000 ten years ago; if your company sold the land today, it would generate $3,000,000 after the taxes were paid. The