ABSTRACT
This chapter discusses the meaning and the underpinnings of 'risk-neutral valuation' and explains how equivalent martingale measures (EMMs) capture the idea of 'risk-neutral valuation', and how they do not. Interestingly, 'risk-neutral valuation' has at least two, not just one, different senses corresponding to the two fundamental theorems of asset pricing. Unfortunately, the notion of EMM tends to be a purely mathematical notion, while risk-neutral valuation is an economic concept. It is important to make the alternative approaches mutually consistent, and this is not always easily accomplished. 'The ability to replicate a European call option means that we can set up a riskless hedge between a long position in it and a short position in units of the underlying stock. The hedge thereby formed is fully riskless.
