Question

Research risk-neutral and real-world probabilities and give an example of each. In your opinion should researchers use real-world or risk-neutral default probabilities for calculating credit value at risk and adjusting the price of a derivative for defaults? Why? How would real-world probabilities affect the credit value? Explain.

Answer 1

Risk neutral probabilities are probabilities of the future outcomes adjusted to the risk that may occur during period. The probabilities are then used to compute the expected asset values or financial holdings.

When we investing on the stock market the risk neutral probability is an important thing to be considered and may help to save your money .

Real world probabilities are those implied by the historical data these really higher than the risk neutral probabilities . Probabilities used in the pricing process donot represent the real probability of the future price hence the current status and other information obtained from the market may change the expected values These probability scenarios should explicitly reference probabilities that take in to account the risk called real world probabilities.  

In my opinion real world probabilities of default should be used for the calculation of the credit value at risk but at the same time risk neutral default probabilities should be used for adjusting the price of derivative for defaults. Parameters such as drift volatilities are market implied and need not correspond to the real distribution. For a risk management application one doesn't need to use the risk neutral and may be focused rather on the real world measure estimated using historical like datas.