2 people form expectation not using the actual

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Unformatted text preview: nt risky cash flows with the risk-free rate they don’t demand an extra premium for bearing risk WRONG! 2 people form expectation not using the actual probabilities, but different probabilities WRONG! So overall this is a ”two wrongs make a right” situation. Relationship between risk-neutral and actual probabilities Risk-neutral probabilities reflect both: The likelihood of the event Investors’ attitude toward these particular risks Remember: the risk-neutral probability came from the current stock price which takes these into account. The difference between risk-neutral probabilities actual probabilities are determined by the risk premium that people demand for holding risk in the digital option. Example S0 1 0 Suppose that in one year from now: “up” path is the unemployment drops below 7% “down” path is unemployment doesn’t drop below 7%. People assess that the probability of “up” is .3. How much would people pay for this security? (r = 2.5%, say) More or les...
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This document was uploaded on 10/28/2013.

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