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Downside risk neutral probabilities

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  • Chaigneau, Pierre
  • Eeckhoudt, Louis

Abstract

Risk neutral probabilities are adjusted to take into account the asset price effect of risk preferences. This paper introduces downside (respectively outer) risk neutral probabilities, which are adjusted to take into account the asset price effect of preferences for downside (resp. outer) risk and higher degree risks. Using risk preference theory, we interpret these three changes in probability measures in terms of risk substitution. With downside risk neutral probabilities, the pricing kernel is linear in wealth. Outer risk neutral probabilities can be viewed as a reasonable approximation of physical probabilities.

Suggested Citation

  • Chaigneau, Pierre & Eeckhoudt, Louis, 2016. "Downside risk neutral probabilities," LSE Research Online Documents on Economics 118980, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:118980
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    File URL: http://eprints.lse.ac.uk/118980/
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    References listed on IDEAS

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    More about this item

    Keywords

    downside risk; pricing kernel; prudence; risk aversion; risk neutral probabilities; risk substitution;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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