Risk-Neutral Valuation: A Gentle Introduction (1) Dinh Gia Theo Rui Ro-Trung Hoa: Phan Gioi Thieu (1) (Vietnamese Version)

60 Pages Posted: 4 Feb 2004

See all articles by Joseph Tham

Joseph Tham

Educational Independent Consultant

Tran Viet Thang

SAIGON COMMERCIAL BANK (SCB); affiliation not provided to SSRN

Date Written: January 1, 2004

Abstract

Risk-neutral valuation is simple, elegant and central in option pricing theory. However, in teaching risk-neutral valuation, it is not easy to explain the concept of "risk-neutral" probabilities. Beginners who are new to risk-neutral valuation always have lingering doubts about the validity of the probabilities. What do the probabilities really mean? Are they real or fictional? Where do they come from? What is the relationship between the risk-neutral probabilities and the actual probabilities? Does it mean that all investors are risk-neutral? When is it appropriate to use the risk-neutral rate as the discount rate?

From a pedagogical point of view, in the beginning it is best to avoid the use of probabilities because probabilities can be a barrier to understanding. Instead, it is far preferable to introduce the idea of state prices and then show that the approach with risk-neutral probabilities is equivalent to the use of state prices.

In this teaching note, we use simple one-period examples to explain the intuitive ideas behind risk-neutral valuation. It is a gentle introduction to risk-neutral valuation, with a minimum requirement of mathematics and prior knowledge. We will provide the motivation and the rationale for calculating state prices and we will show that the risk-neutral approach is simply another way of looking at the issue of state prices.

Keywords: Cost-Benefit Analysis, Capital Budgeting, Project Evaluation

JEL Classification: D61, G31, H43

Suggested Citation

Tham, Joseph and Thang, Tran Viet and Thang, Tran Viet, Risk-Neutral Valuation: A Gentle Introduction (1) Dinh Gia Theo Rui Ro-Trung Hoa: Phan Gioi Thieu (1) (Vietnamese Version) (January 1, 2004). Available at SSRN: https://ssrn.com/abstract=485523 or http://dx.doi.org/10.2139/ssrn.485523

Joseph Tham

Educational Independent Consultant ( email )

Tran Viet Thang (Contact Author)

affiliation not provided to SSRN

SAIGON COMMERCIAL BANK (SCB) ( email )

4- HO XUAN HUONG
Hanoi, 10000
Vietnam
084-04-9438732 (Phone)
084-04-9438734 (Fax)

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