Jun 18

Risk neutral valuation – 9 min screencast

by David Harper, CFA, FRM, CIPM

FRM |

The idea is that we can price an option in the riskless world, yet the result applies in the real (risky) world. The reason is that a higher expected return for the asset (the stock) should be met with (offset by) a higher discount rate. In this screencast example, a probability of an up step (u) of 52.5% and a risk-less rate of 4%…

riskfree_rn1

translates into a real (risky) world assumption of p = 60% and a discount rate of 57%. Then the higher expected return is met with a higher discount rate, such that the option price (present value) is the same:

riskfree_rn2

Screencast:

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