S. Figlewski: What is Risk Neutral Volatility?

December 2, 2012

A security’s expected payoff under the real world distribution for stock returns includes risk premia to compensate investors for bearing different types of stock market risk. But Black-Scholes and the great majority of derivatives valuation models developed from it produce the same option prices as would be seen under modified probabilities in a world of investors who were indifferent to risk. Implied volatility and other parameters extracted from options market prices embed these modified “risk neutral” probabilities, that combine investors’ objective predictions of the real world returns distribution with their risk preferences.