Question

What is meant by risk-neutral pricing of a financial asset? Could you give me a simple definition and use a quick example?

thanks really much

Answer 1

A risk neutral pricing of a financial asset implies that the current price of the financial assets is equal to the expected future price of the asset discounted at the risk free rate of interest.

Example:

Suppose a stock price today is $50. It can either go up or down by $10 in one year and the risk free rate of return is 6%.

So the stock can be either $60 or become $40.

Probability : 50= 60p + 40 (1-p) / 1.06

p = 0.65

Present value of the option = 10 * 0.65 + 0(1-0.65) / 1.06 = 6.13