Choosing Between Risk-Neutral and Physical Probabilities for Forecasting

Summary

The document raises a distinction among probability measures used in quantitative finance. It describes risk-neutral probability as the framework used to price derivatives under no-arbitrage conditions, while identifying physical probability as the relevant framework for risk management. It then asks which measure is appropriate when the objective is forecasting, suggesting physical probability but expressing uncertainty about whether the answer depends on the forecasting task.

No responses, derivation, examples, or empirical evidence are included, so the document does not resolve the question. The useful takeaway is that the probability measure should be tied to the objective: derivative valuation and forecasting answer different questions, and a pricing measure should not automatically be treated as a real-world forecast. The distinction is only sketched here; practical forecasting requires specifying the quantity and horizon of interest, and the text does not discuss how to estimate or validate either probability measure.

Key ideas

• Risk-neutral probabilities are presented as the framework for derivative pricing under no-arbitrage conditions.
• Physical probabilities are identified as relevant to risk management.
• The document asks whether physical probabilities are appropriate for forecasting but does not settle the issue.
• The probability framework should be considered in light of the intended task.

Tags

# Risk neutral probability and forecasting


# Risk neutral probability and forecasting












When our goal is pricing of derivative products we, due to no arbitrage conditions, have to use the risk neutral probability. In other side if we have risk management purpose we have to use the “physical probability” (in this place is better no look in deep what they are). However if our goal, generally speaking, is to do the forecast then what kind of probability we must use ? I think the physical, but I’m not totally sure. Maybe exist different case … I don’t known. What do you think ?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.