17/12/2019 Risk-Neutral Probabilities

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Risk-Neutral Probabilities
By JAMES CHEN | Updated Sep 24, 2019

What Are Risk-Neutral Probabilities?

Risk-neutral probabilities are probabilities of potential future outcomes adjusted for risk,
which are then used to compute expected asset values. In other words, assets and securities
are bought and sold as if the hypothetical fair, single probability for an outcome were a
reality, even though that is not, in fact, the actual scenario.

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KEY TAKEAWAYS
Risk-neutral probabilities are probabilities of possible future outcomes which have
been adjusted for risk.
They can be used to calculate expected asset values. 
These probabilities are used for figuring fair prices for an asset or financial holding.
The idea of risk-neutral probabilities is often used in pricing derivatives. 
The term risk-neutral means an investor would prefer to focus on the potential gains
of an investment rather than the risk attached. 

Understanding Risk-Neutral Probabilities 

Risk-neutral probabilities are used to try to determine objective fair prices for an asset or
financial instrument. You are assessing the probability with the risk taken out of the
equation, so it doesn’t play a factor in the anticipated outcome.

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By contrast, if you tried to estimate the anticipated value of that particular stock based on
how likely it is to go up or down, considering unique factors or market conditions that
influence that specific asset, you would be including risk into the equation and thus would
be looking at real or physical probability.

The benefit of this risk-neutral pricing approach is that 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, which are
sometimes also referred to as physical probabilities. If real-world probabilities were used,
expected values of each security would need to be adjusted for its individual risk profile.

You might think of this approach as a somewhat formalized and structured method of
guessing what the fair and proper price for a security or other financial asset should be by
tracking price trends for other similar assets and then estimating the average to arrive at
your best guess. For this approach, you would try to level out the extreme fluctuations at
either end of the spectrum, creating a balance that creates a stable, level price point. You
would essentially be minimizing the possible unusual high market outcomes while
increasing the possible lows.

Important: Most individual investors do not risk-neutral. More investors fall on

the risk-averse or risk-seeking side, compared to risk-neutral. 

Special Considerations 
RIsk neutral is a term that describes an investor’s appetite for risk. Risk neutral investors are
not concerned with the risk of an investment. However, risk-averse investors have a greater
fear of losing money,  

The term risk-neutral can sometimes be misleading because some people may assume it
means that the investors are neutral, unconcerned or unaware of risk, or that the investment
itself has no risk or has a risk that can somehow be eliminated. However, risk-neutral doesn’t
necessarily imply that the investor is unaware of the risk; instead, it implies the investor
understands the risks but it isn’t factoring it into their decision at the moment. 

The investor prefers to focus on the potential gain of the investment instead. When faced
with two investment options, an investor who is risk-neutral would solely consider the gains

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of each investment, while, for whatever reason, choosing to overlook the risk potential even
though they may be aware of the inherent risk.

Benefits Risk-Neutral Probabilities 

Implementing risk-neutral probability in equations when calculating pricing for fixed-income
financial instruments is useful. This is because you are able to price a security at its trade
price when employing the risk-neutral measure. 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.

Related Terms
Risk Neutral Definition
Risk neutral is a mindset where an investor is indifferent to risk when making an investment decision.
more

How Risk Analysis Works

Risk analysis is the process of assessing the likelihood of an adverse event occurring within the
corporate, government, or environmental sector. more

Risk
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual
return will differ from the expected outcome or return. more

Risk-Neutral Measures
A risk neutral measure is a theoretical measure of a market's risk aversion. more

What Is a Risk Asset?

When an asset's value is subject to substantial volatility that could potentially vacate its worth, it is
called a risk asset. more

Risk-Seeking
Risk-seeking is an acceptance of greater volatility and uncertainty in investments or trading in
exchange for anticipated higher returns. more

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