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Ch20 pg 12

S

Snowy

Member
Costing guarantees
"The use of stochastic modelling using a real world measure may help illustrate the consequences and likelihood of the guarantees coming into effect, but should not of course be used to place a value on guarantees."
Can anyone explain this please?
 
You need to use a risk neutral measure (typically referred to as q in financial economics) to price options, guarantees etc.

However, the risk neutral measure is often different from real world (since there is risk) and the probabilities for an event occuring under the risk neutral measure wouldn't be very realistic.

A real world measure on the other hand will give you reasonable probablities of event occuring but you can't really use it for pricing.
 
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