Question

Explain what is The Risk-Neutral Valuation

Answer 1

Risk Neutral Valuation is the process of valuation of options in terms of expected payoffs. It is calculated in reverse from maturity to current value with the idea that they grow at a risk free rate. i.e the final value is equal to expected present value of payoff, under a risk neutral random walk. The real rate doesn't affect the value.

It is an important concept in derivative segment especially in option writing. Price of assets typically depends upon their risk at the time of valuation and the corresponding changes occurring in the derivative segment of market. In the case of options, where risk neutral valuation is effectively implemented, the buyer don't have an obligation to undertake the deal if the prospect of asset falls outside the risk neutral valuation. Hence risk neutral valuation is used in order to effectively mitigate the risks and since a margin is always present in the case of derivatives, the risk mitigation process can be implemented.