CM2A 2019 September Q5 (ii)

Discussion in 'CM2' started by yuli2513, Sep 16, 2021.

  1. yuli2513

    yuli2513 Very Active Member

    Hi,

    I am struggling to understand why we need to switch to real-life probability measure for Q5 (ii) and why risk-neutral probability measure is considered wrong here. I think these two measures should be equivalent so either one would work.

    Also, I do not understand why in this case the risk-neutral probability of an upward move is higher than the real-life probability of an upward because normally it should be the other way around.

    Can anybody help here? Thanks a lot!
     
    Last edited: Sep 16, 2021
    yuli2513, Sep 16, 2021
    #1
  2. Steve Hales

    Steve Hales ActEd Tutor Staff Member

    Hi
    Risk-neutral probabilities are used to price securities today, real-world probabilities are used to project security prices into the future. The risk-neutral framework is only a mathematical convenience for easier pricing.
    In part (ii) of the question the investor is interested in what happens in the real-world, hence the switch.
    You're correct in saying that p is usually greater than q - and that point was on the marking schedule as something worthy of mention.
     
    Steve Hales, Sep 17, 2021
    #2
    yuli2513 likes this.

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