Risk-Neutral Measures

DEFINITION of 'Risk-Neutral Measures'

A theoretical measure of probability derived from the assumption that the current value of financial assets is equal to their expected payoffs in the future discounted at the risk-free rate. Another assumption made is that there is an absence of arbitrage. The term derives its name from the fact that all financial assets have the same expected rate of return - i.e., the risk-free rate.

Also known as equivalent martingale measure or Q-measure.

BREAKING DOWN 'Risk-Neutral Measures'

The concept of a risk-neutral measure is used to price derivatives. The risk-free rate of return is the return on an investment where the theoretical risk is zero. In practice, the interest rate on three-month U.S. Treasury bills is commonly used as a proxy for the risk-free rate.

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