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CFA Level I · CFA Level I Exam · Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives

Which statement about risk-neutral probabilities is most accurate?

Risk-neutral probabilities are chosen so the underlying's expected future value grows at the risk-free rate. They are a pricing device, not subjective or actual probabilities, and generally differ from real-world probabilities when investors are risk averse.

  1. AThey are the investors' subjective beliefs about the true likelihood of price moves
  2. BThey are set so the underlying's expected value grows at the risk-free rateCorrect
  3. CThey equal the actual probabilities when investors are risk averse

Explanation

Risk-neutral probabilities are constructed so the underlying's expected payoff discounted at the risk-free rate equals its price. They are not real-world probabilities and differ from them when investors demand risk premiums.

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