Explain 'Risk-Neutral Pricing'.

Explain 'Risk-Neutral Pricing'.

Approach: Describe the valuation of derivatives assuming investors are indifferent to risk.

A technique in which the fair value of a derivative is the expected value of its future payoff, discounted at the risk-free rate, under a specific probability measure (the risk-neutral measure).

Follow-up: Does this imply that investors are actually risk-neutral?

Key concepts: martingale measure, expectation, discounting.