Options Pricing with Arithmetic Brownian Motion and its Implication for Risk-Neutral Valuation
Risk-neutral valuation is used widely in derivatives pricing. It is shown in this paper, however, that the naïve approach of simply setting the growth rate of the underlying security to risk-free interest rate, which happens to work for a geometric Brownian motion (GBM) process, fails to work when the underlying price follows the arithmetic Brownian motion (ABM). Therefore, the formal approach using a martingale measure should be used instead when the underlying process is not a GBM.
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