3.2.

1 Risk Neutral Probability

While the future value of stock can never be known with certainty, it is posible to
work out expected stock prices within the binomial tree model. It is then natural to
compare these expected prices and risk-free investments. This simple idea will lead us
towards powerful and surprising applications in the theory of derivative securities (for
example, options, forwards, futures), to be studied in later chapters.
To begin with, we shall work out the dynamics of expected stock prices (()) For

(()) ()( ) ( )()( ) () ( (()))
Where
(()) ( )
Is the expected one-step return. This extends to any as follows.
Proposition 3.4
The expected stock prices for are given by
(()) () ( (()))

Proof
Since the one-step returns () () are independent, so are the random
variabels () () it follows that
(()) (()( ())( ()) ( ()))
()( ())( ()) ( ())
() ( (())) ( (())) ( (()))
Because the () are identically distributed, they all have the same expectation,
(()) (()) (())
Which proves the formula for (())
If the amount () were to be invested risk-free at time it would grow to
()( )

after steps. Clearly, to compare (()) and ()( )

we only need
to compare (() and
An investment in stock always involves an element of risk, simply because the price
() is unknown in advance. A typical risk-averse investor will require-that (())
arguing that he or she should be rewarded with a higher expected return as a
compensation for risk. The reverse situation when (()) may nevertheless be
attractive to some investors if the risky return is high with small non-zero probability and
low with large probability. (A typical example is a lottery, where the expected return is
negative). An investor of this kind can be called a risk-seeker. We shall return to this topic
in chapter 5, where a pricise definition of risk will be developed. The border case of a
market in which (()) is referred to as risk-neutral.
It proves convenient to introduce a special symbol

for the probabilityas well as

for the corresponding expectation satisfying the condition

(())

)
For risk-neutrality, which implies that

We shall call

the risk-neutral probability and

the risk-neutral expectation. It is

important to understand that

is an abstract mathematical object, which may or may

not be equal to the actual market probability Only in a risk-neutral market do we have

Even though the risk-neutral probability

may have no relation to the actual

probability it turns out that for the purpose of valuation of derivate securities the
relevant probability is

rather then This application of the risk-neutral probability,

which is of great practical importance, will be discussed in detail in chapter 8.
Exercise 3.17
Let

Investigate the properties of

as a function of
Exercise 3.18
Show that if and only if

Condition (3.4) implies that

( ) (

)( )
Geometrically, this means that the pair (

) regarded as a vector on the plan

is orthogonal to the vector with coordinates ( ) which represents the

possible one-step gains (or losses) of an investor holding a single share of stock, the
purchase of which was financed by a cash loan attracting interest at a rate , see Figure 3.5.
the line joining the point () and () consists of all points with coordinates ( )
where One of these points corresponds to the actual market probability and
one to the risk-neutral probability.
Another interpretation of condition () for the risk-neutral probability is
illustrated in figure 3.6. if masses

and

are attached at the points with coordinates

and on the real axis, then the centre of mass will be at .