medium · Quantitative Finance stochastic
The 'Market Price of Risk' (Sharpe Ratio) in Girsanov's theorem is defined as θ = (μ - r) / σ.
What is the primary role of θ in derivative pricing?
- It measures the correlation between the stock's returns and the broader market index.
- It defines the deterministic drift shift required to reach the risk-neutral measure.
- It sets the volatility level the asset exhibits under the risk-neutral measure.
- It is used to calculate the fair credit spread on a default swap contract.
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