Lesson 4 of 5 · 12 min
Risk neutrality and risk-neutral probabilities
An option's no-arbitrage value equals its expected payoff, computed with risk-neutral probabilities rather than real ones, discounted at the risk-free rate.
In short
- The risk-neutral probability of an up move is ; the down move gets .
- Option value: , and the same formula with p for a put.
- π depends only on , and r, so the same π values every option on the same underlying over the same period.
- π is not a forecast. It is the probability that would make the underlying's expected return equal to the risk-free rate.
- Risk-neutral pricing: the value does not depend on actual probabilities, on the underlying's expected return or on investors' risk aversion.
Unlock this lesson free for 7 days
Create a free account to get 7 days of full access — every lesson, video, flashcard, mock and the question bank. No card needed.