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Under risk-neutral measure, all assets have expected return at risk-free rate.

This includes stock, or equity prices. But what of the fact that equities typically have higher returns than the risk-free rate (the equity risk premium)?

I am guessing that I am confusing risk-neutral measure with the real-world measure. But then what good is the risk-neutral measure if the expected returns is not what one actually observes in the real-world market?

user9081230912390
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  • I'm voting to close this question are there are already several very similar ones on this site (e.g. https://quant.stackexchange.com/questions/9253/risk-neutral-probability; https://quant.stackexchange.com/questions/17556/why-the-expected-return-rate-of-a-stock-has-nothing-to-do-with-its-option-price/17583#17583; https://quant.stackexchange.com/questions/17032/the-drift-of-stock-price-becomes-the-risk-free-interest-rate-under-rnp). However, if by reading those answers you still have a point which is not clear, you could edit your question to focus on that specific point. – Quantuple Aug 14 '17 at 07:21
  • Risk neutral individuals in risk neutral world don't ask for an extra premium for of the possible downside, even when the expected value of outcome is same as risk free rate. However, investors in real world are usually risk averse and ask for an extra premium based on their individual risk preferences. That's the reason why equities offer higher returns. Ideally, if everyone is RN, equities should also offer risk free rate. Please note that modelling becomes easier when considering a risk neutral model, rather than including the premium which varies for each individual. – honeybadger Aug 15 '17 at 06:09

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