What is the risk-neutral measure

Neutral risk measure is a measure of probability used in financial mathematics to assist in the pricing of derivatives and other financial assets. Risk-neutral measures to give investors a mathematical interpretation of risk prevention of the overall market of a particular asset that must be considered in order to estimate the correct price for the asset. The risk neutral measure is also known as equilibrium measure, or equivalent martingale measure.

Penetration of risk-neutral measures

Was neutral measure the risk of financial mathematicians in order to address the issue of risk aversion in stocks, bonds and derivatives. Modern financial theory suggests that the current value of the asset shall be the sum of the present value of expected future income from that asset. This makes intuitive sense, but there is one problem with this formulation, and that investors are risk-averse, or more afraid of losing money than they are willing to do it. This trend often leads to the fact that the asset price will be slightly lower than expected future income from that asset. As a result, investors and scientists need to compensate for this risk aversion, and risk-neutral measures are an attempt at this.

Risk-neutral measures and the fundamental theorem of asset Pricing

A neutral indicator of risk in the market can be derived using the assumptions held by the fundamental theorem of asset valuation, fundamentals of financial mathematics used for the study of the real financial markets. In the fundamental theorem of asset valuation, it is assumed that there are no arbitrage opportunities or investments that are permanent and reliable making money with no initial cost to the investor. Experience tells us that this is a pretty good assumption for models of real financial markets, although there is, of course, there were exceptions in the history of markets. The fundamental theorem of asset valuation and assumes that markets are complete, this means that markets are indelible, that all actors have full information about what they buy and sell. Finally, he suggests that the price can be obtained for each asset. These assumptions are much less justified, if you think about the real markets, but we need to simplify the world by creating a model.

Only if these assumptions are correct, one neutral risk measure is calculated. Because the assumption, fundamental theorem of asset valuation distorts the real market conditions, it is important not to rely too much on any single calculation in the prices of assets in a financial portfolio.