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Downside Risk Neutral Probabilities

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  • Pierre Chaigneau
  • Louis Eeckhoudt

Abstract

The price of any asset can be expressed with risk neutral probabilities, which are adjusted to incorporate risk preferences. This paper introduces the concepts of downside (respectively outer) risk neutral probabilities, which are adjusted to incorporate the preferences for downside (resp. outer) risk and higher degree risks. We derive new asset pricing formulas that rely on these probability measures. Downside risk neutral probabilities allow to value assets in a simple mean-variance framework. The associated pricing kernel is linear in wealth, as in the CAPM. With outer risk neutral probabilities, the pricing kernel is quadratic in wealth, and can be U-shaped.

Suggested Citation

  • Pierre Chaigneau & Louis Eeckhoudt, 2015. "Downside Risk Neutral Probabilities," Cahiers de recherche 1521, CIRPEE.
    • Handle: RePEc:lvl:lacicr:1521
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    References listed on IDEAS

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    More about this item

    Keywords

    Asset pricing; downside risk; quadratic pricing kernel; linear pricing kernel; prudence; risk neutral probabilities.;
    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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