Stochastic Calculus for Finance I pp 61-87 | Cite as

# State Prices

## Abstract

In the binomial no-arbitrage pricing model of Chapter 1 and also in the continuous-time models formulated in Chapters 4 and 5 of Volume II, there are two probability measures that merit our attention. One is the *actual probability measure*, by which we mean the one that we seek by empirical estimation of the model parameters. The other is the *risk-neutral probability measure*, under which the discounted prices of assets are martingales. These two probability measures give different weights to the asset-price paths in the model. They agree, however, on which price paths are possible (i.e., which paths have positive probability of occurring); they disagree only on what these positive probabilities are. The actual probabilities are the “right” ones. The risk-neutral probabilities are a fictitious but helpful construct because they allow us to neatly summarize the result of solving systems of equations (see, e.g., the system (1.1.3), (1.1.4) of Chapter 1, which leads to the formula (1.1.7) of that chapter).

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