I did not understand this pseudo probablity thing (in derivative) calculations are fine but these values are not actual values ? Pls explain
The concept is there is an up move, there is a down move. Now how does that affect the price of the derivative. mechanics of the move, the numbers behind the move, are beyond the curriculum. (at least for Level II - and thank god for that small mercy).
I assume you are referring to the risk-neutral probabilities. In technical terms, they are not probabilities, but rather a mathematical result of solving simultaneous equations for two variables, and they are the unique values that allow the discounted stock price to be a martingale under this risk-neutral measure. In normal terms, they just happen to have the same properties of probabilities, and are used in the same since that probabilities in an expected value calculation would be, and hence referred to as probabilities, but stictly speaking they are not. cpk123 is correct when he states that it is really beyond CFA scope.
let me break it down. if you ask me how warm it is outside, and I tell you “40” - do you think it’s freezing or hot? if you are an american, you think farehnheit - you think it’s freezing. if you are european, you think celsius - you think it’s hot. the number 40 on its own does not carry much information objectively until you throw the units of measurement behind it. probability numbers also don’t carry much information unless you know the risk preference of the person who assigned those probabilities. the discount rate is a measure of that risk preference. so a risk-neutral probability is un-intuitive to us just like a measurement of the temperature in farenheit is un-intuitive to non-americans. also regarding wyantjs’ statement that the “risk-neutral probabilities” are not probabilities in the strict sense, they just have the same properties as probabilities - i’v seen that view but never quite made sense out of it. if something has the properties of a probability measure, then it is a probability measure, because that’s how probability measure is defined - in terms of its properties. it might be a philosophical question, i don’t know 
Nice explaination MS. I had read this sentence ‘risk preference of the person who assigned those probabilities’ at so many places (in articles/papers) while trying to understand what ‘risk-neutral-probability’ actually meant. Now It all makes sense. Thanks!
Mobius Striptease Wrote: -------------------------------------------------------> > also regarding wyantjs’ statement that the > “risk-neutral probabilities” are not probabilities > in the strict sense, they just have the same > properties as probabilities - i’v seen that view > but never quite made sense out of it. if something > has the properties of a probability measure, then > it is a probability measure, because that’s how > probability measure is defined - in terms of its > properties. it might be a philosophical question, > i don’t know I think you are right when you say it is a philosophical question. Using your argument, if something satisfies all the criteria to be a probability, then I guess it is one. The point is that the original derivation of them was not driven by the intentions of finding a probability. Instead…the driving force was simply to solve for two unknown parameters in a binomial model, and by coincidence they satisfy the definitions.