Risk-Neutral Probabilities

What are 'Risk-Neutral Probabilities'

Risk-neutral probabilities are probabilities of future outcomes adjusted for risk, which are then used to compute expected asset values. The benefit of this risk-neutral pricing approach is that the once the risk-neutral probabilities are calculated, they can be used to price every asset based on its expected payoff. These theoretical risk-neutral probabilities differ from actual real world probabilities; if the latter were used, expected values of each security would need to be adjusted for its individual risk profile.

BREAKING DOWN 'Risk-Neutral Probabilities'

A key assumption in computing risk-neutral probabilities is the absence of arbitrage. The concept of risk-neutral probabilities is widely used in pricing derivatives.

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