Explain the difference between the risk-neutral and actual probabilities. In which states is one higher than the other? Why?

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Part 1

Complete the statement below:(Select from the drop-down menus.)

probabilities are the probabilities with which an event will happen.

Actual

Risk-neutral

probabilities are the probabilities of an event happening in a world where investors are risk-neutral. As such,

actual

risk-neutral

probabilities are a construction and do not reflect reality. Assuming that investors are risk averse,

actual

risk-neutral

probabilities are lower in good states and larger in bad states. This has to be the case because if investors were risk-neutral the expected returns are the

risk-free

risk-neutral

rate, whereas risk averse inventors demand

higher

lower

returns. Also, given the same payoffs, a

higher

lower

expected return implies good states are more likely.