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How's RN pricing related to the (1)supply and demand and (2)utility based pricing method and risk aversion?I think (1) determines any price fundamentally, if the product is traded;(2) is the fundamental way to go, if the product is not traded and is not on market;But how does Risk Neutral pricing related to these two things?-----------------And more over, what's the relation between (1)RN pricing, (2)arbitrage-pricing, (3)law of one price, (4) supply and demand, (5) utility based method?Thanks

I got same question. In addition to your list, I will add CAPM where expected return is risk free only when vola is zero. RN says all asset's expected return is risk free. Future=Spot*exp(rf) applies always irrespective of choice of theory. This is because otherwise arbitrage will eventually flatten the deviation to make Future-Spot*exp(rf) =0. Meanwhile, supply & demand does decide new market price irrespective of risk free rate. From statistics, analysts forcast, then some investors believe in that and invest expecting better yield. For example, assume spot commodity price is 100(1Yr future 105) and forcast of 1Yr maturity price is around 200 where rf=5%. If majority of market participants shares same forcast, the spot price will jump up to 200 immediate and future price to be 210. But if you are the only person who has access to the statistics and you are the only person who reached up to a conclusion that it is highly likely that commodity price will goes up to 200 1Yr later, what will happen ?? Then you will end up creating big long position of that commodity yourself. To decide portfolio allocation ratio you may use CAPM based on your own expected return. But that expected return is your own secret nobody shares. Besides expected return, RN based pricing sometime attributes expected return deviation onto volatility. For example, imagine treasury future option 3M maturity. Based on economical/political/technical analysis, some option market participants may start buying 123 call when ATM is 120. Also assume that that market participants play only on option market but neither on cash nor future. Additionaly imagine that it took few days that public shares same view as that market participants. In that case RN based B/S pricing, expected return is kept unchanged and option price hike is all attributed to the volatility increase. In short, all below methods are used to predict SPOT price. But market will not necessarily follow that. Meanwhile RN pricing assumes perfect market efficiency, all information are shared instant to all market participants and arbitrage will occure everywhere. RN pricing states only mechanical relationship between spot/future. RN pricing cannot be used to make any intelligent price forecast beyond applying Rf rate. (1)supply and demand (2)utility based pricing method and risk aversion(3)law of one price

QuoteOriginally posted by: ponpokoI got same question. In addition to your list, I will add CAPM where expected return is risk free only when vola is zero. RN says all asset's expected return is risk free. Future=Spot*exp(rf) applies always irrespective of choice of theory. This is because otherwise arbitrage will eventually flatten the deviation to make Future-Spot*exp(rf) =0. Meanwhile, supply & demand does decide new market price irrespective of risk free rate. From statistics, analysts forcast, then some investors believe in that and invest expecting better yield. For example, assume spot commodity price is 100(1Yr future 105) and forcast of 1Yr maturity price is around 200 where rf=5%. If majority of market participants shares same forcast, the spot price will jump up to 200 immediate and future price to be 210. But if you are the only person who has access to the statistics and you are the only person who reached up to a conclusion that it is highly likely that commodity price will goes up to 200 1Yr later, what will happen ?? Then you will end up creating big long position of that commodity yourself. To decide portfolio allocation ratio you may use CAPM based on your own expected return. But that expected return is your own secret nobody shares. Besides expected return, RN based pricing sometime attributes expected return deviation onto volatility. For example, imagine treasury future option 3M maturity. Based on economical/political/technical analysis, some option market participants may start buying 123 call when ATM is 120. Also assume that that market participants play only on option market but neither on cash nor future. Additionaly imagine that it took few days that public shares same view as that market participants. In that case RN based B/S pricing, expected return is kept unchanged and option price hike is all attributed to the volatility increase. In short, all below methods are used to predict SPOT price. But market will not necessarily follow that. Meanwhile RN pricing assumes perfect market efficiency, all information are shared instant to all market participants and arbitrage will occure everywhere. RN pricing states only mechanical relationship between spot/future. RN pricing cannot be used to make any intelligent price forecast beyond applying Rf rate. (1)supply and demand (2)utility based pricing method and risk aversion(3)law of one pricewrong forum!!