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 Ï€=1+r−RdRu−Rd\pi = \dfrac{1 + r - R^d}{R^u - R^d}; the down move gets 1−π1 - \pi.
  • Option value: c0=Ï€c1u+(1−π)c1d(1+r)Tc_0 = \dfrac{\pi c_1^u + (1-\pi)c_1^d}{(1+r)^T}, and the same formula with p for a put.
  • Ï€ depends only on RuR^u, RdR^d and r, so the same Ï€ values every option on the same underlying over the same period.
  • Ï€ 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.

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Risk neutrality and risk-neutral probabilities · Valuing a Derivative Using a One-Period Binomial Model