The risk-neutral probabilities for an asset, with a current value equal to the present value of future payoffs are:
A) given by the probability of each state occurring.
B) given by the value of the underlying asset under good news and the risk free rate.
C) given by the value of the underlying asset under good news and bad news.
D) given by the value of the underlying asset under good news, bad news, and the risk free rate.

Question

Quizplus · Accepted Answer

Risk-neutral probabilities are calculated considering the value of the underlying asset in all possible future states (good news, bad news) and discounting those values back to the present using the risk-free rate. This approach ensures that the expected return of the asset is equal to the risk-free rate, as required under risk neutrality.

The Risk-Neutral Probabilities for an Asset, with a Current Value