What is the difference between probability & risk neutralprobability?

Thread starter woundedtiger4
Start date Jun 25, 2013
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In summary, probability is a measure of the likelihood of an event occurring and is calculated by dividing the number of desired outcomes by the total number of possible outcomes. Risk neutral probability is a theoretical concept used in finance that assumes investors are indifferent to risk and is used to calculate the present value of future cash flows. While risk neutral probability has its uses, it does have limitations such as not reflecting actual levels of risk aversion and not accounting for unforeseen events or changes in market conditions.

Jun 25, 2013

woundedtiger4

Are both same or different? Can someone give me some example to understand?

Thanks in advance

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Jun 25, 2013

MarneMath

Education Advisor

Well, probability is a board overarching term, while risk neutral probability is specific measure that tends to occur when talking about a free arbitrage market.

What is the difference between probability and risk neutral probability?

Probability is a measure of the likelihood of an event occurring, expressed as a number between 0 and 1. Risk neutral probability, on the other hand, is a theoretical concept used in financial modeling to represent the probability of future outcomes under the assumption that investors are risk neutral.

How is probability calculated?

Probability is calculated by dividing the number of desired outcomes by the total number of possible outcomes. For example, if you roll a six-sided die, the probability of rolling a 3 would be 1/6 (1 desired outcome out of 6 possible outcomes).

Can probability be greater than 1?

No, probability cannot be greater than 1. A probability of 1 means that the event is certain to occur, while a probability of 0 means that the event will not occur. Any number between 0 and 1 represents the likelihood of the event occurring.

How is risk neutral probability used in finance?

Risk neutral probability is used in finance to calculate the present value of future cash flows. It assumes that investors are indifferent to risk, so the expected return on an investment is the same as the risk-free rate. This allows for easier comparison and evaluation of different investment options.

What are some limitations of using risk neutral probability?

One limitation of using risk neutral probability is that it does not reflect the actual levels of risk aversion among investors. It also assumes that markets are efficient and do not have any frictions, which may not always be the case in reality. Additionally, it does not account for unforeseen events or changes in market conditions that may impact the actual probabilities of future outcomes.