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There are two approaches to asset valuation: one based on CAPM using physical probability P, and one using risk-neutral probability Q. Under P, assets are discounted using the cost of equity. Under Q, assets are discounted at the risk-free rate. Both approaches can be valid. Q probability embeds information from P as well as investor preferences through a price deflator. The first fundamental theorem of asset pricing shows that under Q, all risky securities have an expected return equal to the risk-free rate, making Q a risk-neutral measure. Investors need information on both P and the price deflator to have full information when valuing assets.

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Andrea Pazzini
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50 views3 pages

Kernel Pricing

There are two approaches to asset valuation: one based on CAPM using physical probability P, and one using risk-neutral probability Q. Under P, assets are discounted using the cost of equity. Under Q, assets are discounted at the risk-free rate. Both approaches can be valid. Q probability embeds information from P as well as investor preferences through a price deflator. The first fundamental theorem of asset pricing shows that under Q, all risky securities have an expected return equal to the risk-free rate, making Q a risk-neutral measure. Investors need information on both P and the price deflator to have full information when valuing assets.

Uploaded by

Andrea Pazzini
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Kernel Pricing

There are two asset valuation approaches, one coming from corporate finance and based on
CAPM (under physical probability P):
1
𝑆!" = ∗ 𝐸 " [𝑆& (𝑤)]
1 + 𝜇#$"%

where 𝜇#$"% = 𝑅' + 𝛽 ∗ (𝜇% − 𝑅' )

and you must use as a discount factor the return on equity, which accounts for the risk.

Then, you have a risk-neutral approach under Q probability:

1
𝑆!( = ∗ 𝐸 ( [𝑆& (𝑤)]
1 + 𝑅'
where you discount at the risk-free rate.

Which one is the right one? Or both of them are right?

How to move from P to Q: Risk-neutral measure

If we define a new varaible, called a price deflator, as the normalized level of marginal
utility:

We assume that we are in a market where there is a monopolist that has so much power that is
able to set prices.
At the numerator we have the marginal utility of this monopolist, while at the denominator we
have the expectation of such utility under probability P.

We get that the F.O.C. implies:

The marginal utility of the monopolist U’ is positive (non-satiated) and decreasing (since the
investor is assumed to be risk-averse and therefore its second derivative is negative).
We can define the Q measure in terms of P measure:

The expected value of m is usually 1 by construction since m is equal to U’ over its expectation.
So, the denominator does not have an impact and Q = m * P.

Main result: The Q probability measure embeds the information you get from P (likelihood of
an outcome), but also the information on the marginal utility of the investor
(preference). So, Q is not a “pure” probability measure like P, it is also influenced by the
monopolist preference.

The valuation equation implied by the first order condition can be restated as:

We get that under this new probability measure, every risky security has an expected return
equal to the risk-free.
So, we call this measure a risk-neutral probability, since under it every investor behaves as if the
market was risk-free as if they are risk-neutral.

Investors must receive from the authorities information about P, because the real risk of an
investment is under P. On top of that, it is also important to disclose the preference of, for
instance, Bank of China (monopolist), that will invest to keep prices consistent with its own
preferences.
So, as an investor, you need both information on P and information on m to have full information.
Knowing Q alone is not sufficient, you must look at the single components: P, the likelihood of
a scenario; and m, the preferences of a large investor.
First FTAP

From what we have just described we can get to the first FTAP:

Then, you have a risk-neutral approach under Q probability:

1 1
𝑆!( = ∗ 𝐸 ( 1𝑆&(*) 2 = ∗ 𝐸 " [𝑚(𝑤) ∗ 𝑆& (𝑤)]
1 + 𝑅' 1 + 𝑅'
Compare it with:
1
𝑆!" = ∗ 𝐸 " [𝑆& (𝑤)]
1 + 𝜇#$"%

Is there an m(w) that makes CAPM valuation equal to risk-neutral valuation?

Yes the solution is:

By choosing m in that way we get the equivalence between CAPM and RN valuation.

Looking at the numerical example we understand that:


• “M(w)”, i.e. the preference, is adjusting the value of €1 in different states of nature.
According to the decreasing marginal utility of a risk-averse investor, the value of €1 will
be higher when you end up in the down state (and therefore you are poorer). That’s why
M(w) is higher in the down state with respect to the up state

GUARDA GLI ULTIMI 3 MINUTI DELLA LEZIONE DOVE SPIEGA Q VS P PER INVESTMENT BANKS E
INSURANCE COMPANIES TI FA CAPIRE CHI USA COSA

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