18.
600: Lecture 35
Martingales and risk neutral probability
Scott Sheffield
MIT
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Recall martingale definition
I Let S be the probability space. Let X0 , X1 , X2 , . . . be a
sequence of real random variables. Interpret Xi as price of
asset at ith time step.
Recall martingale definition
I Let S be the probability space. Let X0 , X1 , X2 , . . . be a
sequence of real random variables. Interpret Xi as price of
asset at ith time step.
I Say Xn sequence is a martingale if E [|Xn |] < for all n and
E [Xn+1 |Fn ] = Xn for all n.
Recall martingale definition
I Let S be the probability space. Let X0 , X1 , X2 , . . . be a
sequence of real random variables. Interpret Xi as price of
asset at ith time step.
I Say Xn sequence is a martingale if E [|Xn |] < for all n and
E [Xn+1 |Fn ] = Xn for all n.
I Given all I know today, expected price tomorrow is the price
today.
Recall stopping time definition
I Let T be a non-negative integer valued random variable.
Recall stopping time definition
I Let T be a non-negative integer valued random variable.
I Think of T as giving the time the asset will be sold if the
price sequence is X0 , X1 , X2 , . . ..
Recall stopping time definition
I Let T be a non-negative integer valued random variable.
I Think of T as giving the time the asset will be sold if the
price sequence is X0 , X1 , X2 , . . ..
I Say that T is a stopping time if the event that T = n
depends only on the values Xi for i n. In other words, the
decision to sell at time n depends only on prices up to time n,
not on (as yet unknown) future prices.
Examples
I Suppose that an asset price is a martingale that starts at 50
and changes by increments of 1 at each time step. What is
the probability that the price goes down to 40 before it goes
up to 70?
Examples
I Suppose that an asset price is a martingale that starts at 50
and changes by increments of 1 at each time step. What is
the probability that the price goes down to 40 before it goes
up to 70?
I What is the probability that it goes down to 45 then up to 55
then down to 45 then up to 55 again all before reaching
either 0 or 100?
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
I In previous lectures, we interpreted the conditional
expectation E [X |Y ] as a random variable.
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
I In previous lectures, we interpreted the conditional
expectation E [X |Y ] as a random variable.
I Depends only on Y . Describes expectation of X given
observed Y value.
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
I In previous lectures, we interpreted the conditional
expectation E [X |Y ] as a random variable.
I Depends only on Y . Describes expectation of X given
observed Y value.
I We showed E [E [X |Y ]] = E [X ].
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
I In previous lectures, we interpreted the conditional
expectation E [X |Y ] as a random variable.
I Depends only on Y . Describes expectation of X given
observed Y value.
I We showed E [E [X |Y ]] = E [X ].
I This means that the three-element sequence E [X ], E [X |Y ], X
is a martingale.
Martingales as successively revised best guesses
I The two-element sequence E [X ], X is a martingale.
I In previous lectures, we interpreted the conditional
expectation E [X |Y ] as a random variable.
I Depends only on Y . Describes expectation of X given
observed Y value.
I We showed E [E [X |Y ]] = E [X ].
I This means that the three-element sequence E [X ], E [X |Y ], X
is a martingale.
I More generally, E [X |F0 ], E [X |F1 ], E [X |F2 ], . . . is a
martingale,
Martingales as sequentially updated probability estimates
I Example: let C be the amount of oil available for drilling
under a particular piece of land. Suppose that ten geological
tests are done that will ultimately determine the value of C .
Let Cn be the conditional expectation of C given the
outcome of the first n of these tests. Then the sequence
C0 , C1 , C2 , . . . , C10 = C is a martingale.
Martingales as sequentially updated probability estimates
I Example: let C be the amount of oil available for drilling
under a particular piece of land. Suppose that ten geological
tests are done that will ultimately determine the value of C .
Let Cn be the conditional expectation of C given the
outcome of the first n of these tests. Then the sequence
C0 , C1 , C2 , . . . , C10 = C is a martingale.
I Let Ai be my best guess at the probability that a basketball
team will win the game, given the outcome of the first i
minutes of the game. Then Ai is a martingale.
Martingales as sequentially updated probability estimates
I Example: let C be the amount of oil available for drilling
under a particular piece of land. Suppose that ten geological
tests are done that will ultimately determine the value of C .
Let Cn be the conditional expectation of C given the
outcome of the first n of these tests. Then the sequence
C0 , C1 , C2 , . . . , C10 = C is a martingale.
I Let Ai be my best guess at the probability that a basketball
team will win the game, given the outcome of the first i
minutes of the game. Then Ai is a martingale.
I These stories basically assume that I have some a priori
probability measure on the set of all possible outcomes and I
am computing conditional probabilities with respect to that.
Martingales as sequentially updated probability estimates
I Example: let C be the amount of oil available for drilling
under a particular piece of land. Suppose that ten geological
tests are done that will ultimately determine the value of C .
Let Cn be the conditional expectation of C given the
outcome of the first n of these tests. Then the sequence
C0 , C1 , C2 , . . . , C10 = C is a martingale.
I Let Ai be my best guess at the probability that a basketball
team will win the game, given the outcome of the first i
minutes of the game. Then Ai is a martingale.
I These stories basically assume that I have some a priori
probability measure on the set of all possible outcomes and I
am computing conditional probabilities with respect to that.
I As long as Ai is defined from my probability measure, it will
be a martingale w.r.t. to my probability measure.
Martingales as sequentially updated probability estimates
I Example: let C be the amount of oil available for drilling
under a particular piece of land. Suppose that ten geological
tests are done that will ultimately determine the value of C .
Let Cn be the conditional expectation of C given the
outcome of the first n of these tests. Then the sequence
C0 , C1 , C2 , . . . , C10 = C is a martingale.
I Let Ai be my best guess at the probability that a basketball
team will win the game, given the outcome of the first i
minutes of the game. Then Ai is a martingale.
I These stories basically assume that I have some a priori
probability measure on the set of all possible outcomes and I
am computing conditional probabilities with respect to that.
I As long as Ai is defined from my probability measure, it will
be a martingale w.r.t. to my probability measure.
I This is not a statement about how well informed my
probability measure is.
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
I Exciting!!! Of course I said Id have to talk to you first, 24
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
I Exciting!!! Of course I said Id have to talk to you first, 24
I because you are absolutely a priority in my life, 8
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
I Exciting!!! Of course I said Id have to talk to you first, 24
I because you are absolutely a priority in my life, 8
I and youll be at MIT for at least three more years... 11
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
I Exciting!!! Of course I said Id have to talk to you first, 24
I because you are absolutely a priority in my life, 8
I and youll be at MIT for at least three more years... 11
I but Im just so confused on so many levels. 15
Martingales as real time subjective probability estimates
I Ivan sees email from girlfriend with subject some possibly
serious news, thinks theres a 20 percent chance shell break
up with him by emails end. Revises number after each line:
I Oh Ivan, Ive missed you so much! 12
I I have something crazy to tell you, 24
I and so sorry to do this by email. (Wheres your phone!?) 38
I Ive been spending lots of time with a guy named Robert, 52
I a visiting database consultant on my project 34
I who seems very impressed by my work. 23
I Robert wants me to join his startup in Palo Alto. 38
I Exciting!!! Of course I said Id have to talk to you first, 24
I because you are absolutely a priority in my life, 8
I and youll be at MIT for at least three more years... 11
I but Im just so confused on so many levels. 15
I Call me!!! I love you! Alice 0
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Outline
Martingales and stopping times
Martingales and Bayesian expectation revisions
Risk neutral probability and martingales
Martingales applied to finance
I Many asset prices are believed to behave approximately like
martingales, at least in the short term.
Martingales applied to finance
I Many asset prices are believed to behave approximately like
martingales, at least in the short term.
I Efficient market hypothesis: new information is instantly
absorbed into the stock value, so expected value of the stock
tomorrow should be the value today. (If it were higher,
statistical arbitrageurs would bid up todays price until this
was not the case.)
Martingales applied to finance
I Many asset prices are believed to behave approximately like
martingales, at least in the short term.
I Efficient market hypothesis: new information is instantly
absorbed into the stock value, so expected value of the stock
tomorrow should be the value today. (If it were higher,
statistical arbitrageurs would bid up todays price until this
was not the case.)
I But there are some caveats: interest, risk premium, etc.
Martingales applied to finance
I Many asset prices are believed to behave approximately like
martingales, at least in the short term.
I Efficient market hypothesis: new information is instantly
absorbed into the stock value, so expected value of the stock
tomorrow should be the value today. (If it were higher,
statistical arbitrageurs would bid up todays price until this
was not the case.)
I But there are some caveats: interest, risk premium, etc.
I According to the fundamental theorem of asset pricing,
the discounted price XA(n)
(n)
, where A is a risk-free asset, is a
martingale with respected to risk neutral probability.
Risk neutral probability
I Risk neutral probability is a fancy term for market
probability. (The term market probability is arguably more
descriptive.)
Risk neutral probability
I Risk neutral probability is a fancy term for market
probability. (The term market probability is arguably more
descriptive.)
I That is, it is a probability measure that you can deduce by
looking at prices on market.
Risk neutral probability
I Risk neutral probability is a fancy term for market
probability. (The term market probability is arguably more
descriptive.)
I That is, it is a probability measure that you can deduce by
looking at prices on market.
I For example, suppose somebody is about to shoot a free
throw in basketball. What is the price in the sports betting
world of a contract that pays one dollar if the shot is made?
Risk neutral probability
I Risk neutral probability is a fancy term for market
probability. (The term market probability is arguably more
descriptive.)
I That is, it is a probability measure that you can deduce by
looking at prices on market.
I For example, suppose somebody is about to shoot a free
throw in basketball. What is the price in the sports betting
world of a contract that pays one dollar if the shot is made?
I If the answer is .75 dollars, then we say that the risk neutral
probability that the shot will be made is .75.
Risk neutral probability
I Risk neutral probability is a fancy term for market
probability. (The term market probability is arguably more
descriptive.)
I That is, it is a probability measure that you can deduce by
looking at prices on market.
I For example, suppose somebody is about to shoot a free
throw in basketball. What is the price in the sports betting
world of a contract that pays one dollar if the shot is made?
I If the answer is .75 dollars, then we say that the risk neutral
probability that the shot will be made is .75.
I Risk neutral probability is the probability determined by the
market betting odds.
Risk neutral probability of outcomes known at fixed time T
I Risk neutral probability of event A: PRN (A) denotes
Price{Contract paying 1 dollar at time T if A occurs }
.
Price{Contract paying 1 dollar at time T no matter what }
Risk neutral probability of outcomes known at fixed time T
I Risk neutral probability of event A: PRN (A) denotes
Price{Contract paying 1 dollar at time T if A occurs }
.
Price{Contract paying 1 dollar at time T no matter what }
I If risk-free interest rate is constant and equal to r
(compounded continuously), then denominator is e rT .
Risk neutral probability of outcomes known at fixed time T
I Risk neutral probability of event A: PRN (A) denotes
Price{Contract paying 1 dollar at time T if A occurs }
.
Price{Contract paying 1 dollar at time T no matter what }
I If risk-free interest rate is constant and equal to r
(compounded continuously), then denominator is e rT .
I Assuming no arbitrage (i.e., no risk free profit with zero
upfront investment), PRN satisfies axioms of probability. That
is, 0 PRN (A) 1, and PRN (S) = 1, and if events Aj are
disjoint then PRN (A1 A2 . . .) = PRN (A1 ) + PRN (A2 ) + . . .
Risk neutral probability of outcomes known at fixed time T
I Risk neutral probability of event A: PRN (A) denotes
Price{Contract paying 1 dollar at time T if A occurs }
.
Price{Contract paying 1 dollar at time T no matter what }
I If risk-free interest rate is constant and equal to r
(compounded continuously), then denominator is e rT .
I Assuming no arbitrage (i.e., no risk free profit with zero
upfront investment), PRN satisfies axioms of probability. That
is, 0 PRN (A) 1, and PRN (S) = 1, and if events Aj are
disjoint then PRN (A1 A2 . . .) = PRN (A1 ) + PRN (A2 ) + . . .
I Arbitrage example: if A and B are disjoint and
PRN (A B) < P(A) + P(B) then we sell contracts paying 1 if
A occurs and 1 if B occurs, buy contract paying 1 if A B
occurs, pocket difference.
Risk neutral probability differ vs. ordinary probability
I At first sight, one might think that PRN (A) describes the
markets best guess at the probability that A will occur.
Risk neutral probability differ vs. ordinary probability
I At first sight, one might think that PRN (A) describes the
markets best guess at the probability that A will occur.
I But suppose A is the event that the government is dissolved
and all dollars become worthless. What is PRN (A)?
Risk neutral probability differ vs. ordinary probability
I At first sight, one might think that PRN (A) describes the
markets best guess at the probability that A will occur.
I But suppose A is the event that the government is dissolved
and all dollars become worthless. What is PRN (A)?
I Should be 0. Even if people think A is likely, a contract
paying a dollar when A occurs is worthless.
Risk neutral probability differ vs. ordinary probability
I At first sight, one might think that PRN (A) describes the
markets best guess at the probability that A will occur.
I But suppose A is the event that the government is dissolved
and all dollars become worthless. What is PRN (A)?
I Should be 0. Even if people think A is likely, a contract
paying a dollar when A occurs is worthless.
I Now, suppose there are only 2 outcomes: A is event that
economy booms and everyone prospers and B is event that
economy sags and everyone is needy. Suppose purchasing
power of dollar is the same in both scenarios. If people think
A has a .5 chance to occur, do we expect PRN (A) > .5 or
PRN (A) < .5?
Risk neutral probability differ vs. ordinary probability
I At first sight, one might think that PRN (A) describes the
markets best guess at the probability that A will occur.
I But suppose A is the event that the government is dissolved
and all dollars become worthless. What is PRN (A)?
I Should be 0. Even if people think A is likely, a contract
paying a dollar when A occurs is worthless.
I Now, suppose there are only 2 outcomes: A is event that
economy booms and everyone prospers and B is event that
economy sags and everyone is needy. Suppose purchasing
power of dollar is the same in both scenarios. If people think
A has a .5 chance to occur, do we expect PRN (A) > .5 or
PRN (A) < .5?
I Answer: PRN (A) < .5. People are risk averse. In second
scenario they need the money more.
Non-systemic event
I Suppose that A is the event that the Boston Red Sox win the
World Series. Would we expect PRN (A) to represent (the
markets best assessment of) the probability that the Red Sox
will win?
Non-systemic event
I Suppose that A is the event that the Boston Red Sox win the
World Series. Would we expect PRN (A) to represent (the
markets best assessment of) the probability that the Red Sox
will win?
I Arguably yes. The amount that people in general need or
value dollars does not depend much on whether A occurs
(even though the financial needs of specific individuals may
depend on heavily on A).
Non-systemic event
I Suppose that A is the event that the Boston Red Sox win the
World Series. Would we expect PRN (A) to represent (the
markets best assessment of) the probability that the Red Sox
will win?
I Arguably yes. The amount that people in general need or
value dollars does not depend much on whether A occurs
(even though the financial needs of specific individuals may
depend on heavily on A).
I Even if some people bet based on loyalty, emotion, insurance
against personal financial exposure to teams prospects, etc.,
there will arguably be enough in-it-for-the-money statistical
arbitrageurs to keep price near a reasonable guess of what
well-informed informed experts would consider the true
probability.
Extensions of risk neutral probability
I Definition of risk neutral probability depends on choice of
currency (the so-called numeraire).
Extensions of risk neutral probability
I Definition of risk neutral probability depends on choice of
currency (the so-called numeraire).
I Before the 2016 US presidential election, investors predicted
(correctly) that the value of the Mexican peso (in US dollars)
would be substantially lower if Trump won than if Clinton won.
Extensions of risk neutral probability
I Definition of risk neutral probability depends on choice of
currency (the so-called numeraire).
I Before the 2016 US presidential election, investors predicted
(correctly) that the value of the Mexican peso (in US dollars)
would be substantially lower if Trump won than if Clinton won.
I Given this, would the risk neutral probability of a Trump win
have been higher with pesos as the numeraire or with dollars
as the numeraire?
Extensions of risk neutral probability
I Definition of risk neutral probability depends on choice of
currency (the so-called numeraire).
I Before the 2016 US presidential election, investors predicted
(correctly) that the value of the Mexican peso (in US dollars)
would be substantially lower if Trump won than if Clinton won.
I Given this, would the risk neutral probability of a Trump win
have been higher with pesos as the numeraire or with dollars
as the numeraire?
I Risk neutral probability can be defined for variable times and
variable interest rates e.g., one can take the numeraire to
be amount one dollar in a variable-interest-rate money market
account has grown to when outcome is known. Can define
PRN (A) to be price of contract paying this amount if and
when A occurs.
Extensions of risk neutral probability
I Definition of risk neutral probability depends on choice of
currency (the so-called numeraire).
I Before the 2016 US presidential election, investors predicted
(correctly) that the value of the Mexican peso (in US dollars)
would be substantially lower if Trump won than if Clinton won.
I Given this, would the risk neutral probability of a Trump win
have been higher with pesos as the numeraire or with dollars
as the numeraire?
I Risk neutral probability can be defined for variable times and
variable interest rates e.g., one can take the numeraire to
be amount one dollar in a variable-interest-rate money market
account has grown to when outcome is known. Can define
PRN (A) to be price of contract paying this amount if and
when A occurs.
I For simplicity, we focus on fixed time T , fixed interest rate r
in this lecture.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
I Unlike true probability (what does that mean?) the risk
neutral probability is an objectively measurable price.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
I Unlike true probability (what does that mean?) the risk
neutral probability is an objectively measurable price.
I Pundit: The market predictions are ridiculous. I can estimate
probabilities much better than they can.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
I Unlike true probability (what does that mean?) the risk
neutral probability is an objectively measurable price.
I Pundit: The market predictions are ridiculous. I can estimate
probabilities much better than they can.
I Listener: Then why not make some bets and get rich? If your
estimates are so much better, law of large numbers says youll
surely come out way ahead eventually.
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
I Unlike true probability (what does that mean?) the risk
neutral probability is an objectively measurable price.
I Pundit: The market predictions are ridiculous. I can estimate
probabilities much better than they can.
I Listener: Then why not make some bets and get rich? If your
estimates are so much better, law of large numbers says youll
surely come out way ahead eventually.
I Pundit: Well, you know... been busy... scruples about
gambling... more to life than money...
Risk neutral probability is objective
I Check out binary prediction contracts at [Link],
[Link], [Link], etc.
I Many financial derivatives are essentially bets of this form.
I Unlike true probability (what does that mean?) the risk
neutral probability is an objectively measurable price.
I Pundit: The market predictions are ridiculous. I can estimate
probabilities much better than they can.
I Listener: Then why not make some bets and get rich? If your
estimates are so much better, law of large numbers says youll
surely come out way ahead eventually.
I Pundit: Well, you know... been busy... scruples about
gambling... more to life than money...
I Listener: Yeah, thats what I thought.
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
I Answer: (2PRN (A) + 3PRN (B))e rT .
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
I Answer: (2PRN (A) + 3PRN (B))e rT .
I Generally, in absence of arbitrage, price of contract that pays
X at time T should be ERN (X )e rT where ERN denotes
expectation with respect to the risk neutral probability.
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
I Answer: (2PRN (A) + 3PRN (B))e rT .
I Generally, in absence of arbitrage, price of contract that pays
X at time T should be ERN (X )e rT where ERN denotes
expectation with respect to the risk neutral probability.
I Example: if a non-divided paying stock will be worth X at
time T , then its price today should be ERN (X )e rT .
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
I Answer: (2PRN (A) + 3PRN (B))e rT .
I Generally, in absence of arbitrage, price of contract that pays
X at time T should be ERN (X )e rT where ERN denotes
expectation with respect to the risk neutral probability.
I Example: if a non-divided paying stock will be worth X at
time T , then its price today should be ERN (X )e rT .
I In particular, the risk neutral expectation of tomorrows
(interest discounted) stock price is todays stock price.
Prices as expectations
I If r is risk free interest rate, then by definition, price of a
contract paying dollar at time T if A occurs is PRN (A)e rT .
I If A and B are disjoint, what is the price of a contract that
pays 2 dollars if A occurs, 3 if B occurs, 0 otherwise?
I Answer: (2PRN (A) + 3PRN (B))e rT .
I Generally, in absence of arbitrage, price of contract that pays
X at time T should be ERN (X )e rT where ERN denotes
expectation with respect to the risk neutral probability.
I Example: if a non-divided paying stock will be worth X at
time T , then its price today should be ERN (X )e rT .
I In particular, the risk neutral expectation of tomorrows
(interest discounted) stock price is todays stock price.
I Implies fundamental theorem of asset pricing, which says
discounted price XA(n)
(n)
(where A is a risk-free asset) is a
martingale with respected to risk neutral probability.