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P15 Derivative Risk Neutral Method
P15 Derivative Risk Neutral Method
Risk-Neutral Method
Risk-neutral refers to a situation where individuals or investors are indifferent to risk when
making financial decisions. In a risk-neutral setting, the expected return on an investment is
considered more important than the level of risk associated with it.
One common application of risk-neutral pricing is in the field of financial derivatives, such as
options. The Black-Scholes model, for example, is a widely used method for pricing options
under the assumption of risk neutrality. This model provides a mathematical formula to
estimate the fair market value of options based on factors like the current stock price, the
option's strike price, time to expiration, and implied volatility.
1. Assumptions:
Stock prices follow a geometric Brownian motion.
Investors are risk-neutral.
There is no transaction cost or taxes.
The risk-free interest rate is constant.
There are no dividends paid on the stock.
8. Market Consistency:
Risk-neutral pricing aims to make financial models consistent with observed
market prices.
If markets are indeed risk-neutral, the calculated prices should align with the
prevailing market prices of financial instruments.