Definition of Risk-neutral measures:
A risk neutral measure is a probability measure used in mathematical finance to aid in pricing derivatives and other financial assets. Risk neutral measures give investors a mathematical interpretation of the overall market’s risk averseness to a particular asset, which must be taken into account in order to estimate the correct price for that asset. A risk neutral measure is also known as an equilibrium measure or equivalent martingale measure. .
Risk neutral measures were developed by financial mathematicians in order to account for the problem of risk aversion in stock, bond, and derivatives markets. Modern financial theory says that the current value of an asset should be worth the present value of the expected future returns on that asset. This makes intuitive sense, but there is one problem with this formulation, and that is that investors are risk averse, or more afraid to lose money than they are eager to make it. This tendency often results in the price of an asset being somewhat below the expected future returns on this asset. As a result, investors and academics must adjust for this risk aversion; risk-neutral measures are an attempt at this. .
A probability measure that is used to evaluate the worth of derivatives. It is a necessary and frequently used concept in mathematical finance. The risk-neutral measure is derived from the calculation of the price of assets that does not have any risk involved with them.
Meaning of Risk-neutral measures & Risk-neutral measures Definition