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Unformatted text preview: nt risky cash ﬂows with the riskfree 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 riskneutral and actual probabilities Riskneutral probabilities reﬂect both:
The likelihood of the event
Investors’ attitude toward these particular risks
Remember: the riskneutral probability came from the current
stock price which takes these into account.
The diﬀerence between
riskneutral 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.
 Spring '13

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