<p>[Edited to reflect @denesp comments]</p>

<p>In asset pricing, the present value of an asset depends on expectations about the future. If you are sure asset A will be worth 100 tomorrow, it is likely to be worth 100/(1+r) today. If you think it might be worth 100 in scenario I or 0 in scenario II with a 1/2 probability each, then its worth [(1/2)*(100) + (1/2)(0)]/(1+r) = 50/(1+r) today.</p>

<p>But, now add the following twist: what if even though the chances of scenarios I and II are 1/2 each, you observe that the asset is worth more than 50/(1+r). Why could this be? </p>

<ul>
<li><p>One reason could be that even though the probabilities are 1/2 and 1/2, investors thing they are 3/4 and 1/4 maybe. These would be the "subjective probabilities" according to most direct sources.<a href="http://www.investopedia.com/terms/s/subjective_probability.asp" rel="nofollow">Investopedia Subjective Probability</a></p></li>
<li><p>Another reason could be that investors know that, for some reason, if scenario I comes round they will be desperate for cash, but if scenario II comes round they will be rich from other income sources anyway. If that's the case then they are more <em>interested</em> in the value of the asset in scenario I than in scenario II. Then they  value the asset as being worth, maybe,[(3/4)<em>(100) + (1/4)</em>(0)]/(1+r)=75/(1+r), because the Scenario I payoffs are worth more to them than the Scenario II payoffs.</p></li>
</ul>

<p>In any case, if you observe the price to be 75/(1+r) then the numbers 3/4 and 1/4, which look like probabilities, are called the "risk-neutral probabilities". They are "weights" that look like probabilities, that describe two things: investor's subjective assessment of the likelihood of the two scenarios, plus the "importance" they put on different future states of nature, beyond the likelihood of their realization.</p>

<p>These risk neutral probabilities are at the core of the paradigm that economists use to model asset prices .</p>

CC BY-SA 3.0
2016-05-05T17:20:31.950Z
This seems very inaccurate. It is the utility of the money that changes, not the perceived probability of the outcome.
Giskard
CC BY-SA 3.0
2016-05-05T18:08:36.053Z
OK. I'm positive this is how some people use these terms, but I can't find any references that say exactly that, so I think you are right, that this is not the most appealing interpretation of these terms. ... will rewrite.
Fix.B.
CC BY-SA 3.0
2016-05-05T15:37:51.153Z
2016-05-08T21:03:38.557Z
2016-05-08T21:03:38.557Z
Fix.B.
<p>How does one differentiate between "objective" and "subjective" probability distributions in asset pricing models?</p>

<p>In asset pricing, economists often make a distinction between the "subjective" and the "objective" probabilities of future states of the world. What do they mean by this?</p>

CC BY-SA 3.0
2015-11-20T17:22:06.197Z
https://en.wikipedia.org/wiki/Probability_interpretations
Herr K.
CC BY-SA 3.0
2016-05-05T09:53:07.007Z
I'm voting to close this question as off-topic because it's not about economics. It might have worked on [philosophy.se] or [stats.se], but I expect a variant answer of it has already been asked and answered on each.
410 gone
CC BY-SA 3.0
2016-05-06T14:48:33.787Z
I disagree with the close votes. I think this is a relevant economic question that is a topic of active research.
cc7768
CC BY-SA 3.0
2016-05-06T20:25:08.943Z
@cc7768 The question was heavily edited yesterday. And not by the OP. And for some reason folks saw it fit to approve the edit rather than encourage a new question.
Giskard
CC BY-SA 3.0
2016-05-07T01:00:28.280Z
@denesp got it. I should read edits beforehand.
cc7768
<econometrics><statistics><asset-pricing>
Difference between objective and subjective distributions in asset pricing models?
user258458
# Difference between objective and subjective distributions in asset pricing models?

(Asked by: username_0 on 2015-11-20)

How does one differentiate between "objective" and "subjective" probability distributions in asset pricing models?

In asset pricing, economists often make a distinction between the "subjective" and the "objective" probabilities of future states of the world. What do they mean by this?

**Tags:** econometrics, statistics, asset-pricing

> **Comments:**
> **username_1**: https://en.wikipedia.org/wiki/Probability_interpretations  
> **username_2**: I'm voting to close this question as off-topic because it's not about economics. It might have worked on [philosophy.se] or [stats.se], but I expect a variant answer of it has already been asked and answered on each.  
> **username_3**: I disagree with the close votes. I think this is a relevant economic question that is a topic of active research.  
> **username_4**: @username_3 The question was heavily edited yesterday. And not by the OP. And for some reason folks saw it fit to approve the edit rather than encourage a new question.  
> **username_3**: @denesp got it. I should read edits beforehand.  

---

## 1 answers

### Answer by username_5 on 2016-05-05. Score: 2

[Edited to reflect @denesp comments]

In asset pricing, the present value of an asset depends on expectations about the future. If you are sure asset A will be worth 100 tomorrow, it is likely to be worth 100/(1+r) today. If you think it might be worth 100 in scenario I or 0 in scenario II with a 1/2 probability each, then its worth [(1/2)\*(100) + (1/2)(0)]/(1+r) = 50/(1+r) today.

But, now add the following twist: what if even though the chances of scenarios I and II are 1/2 each, you observe that the asset is worth more than 50/(1+r). Why could this be?

* One reason could be that even though the probabilities are 1/2 and 1/2, investors thing they are 3/4 and 1/4 maybe. These would be the "subjective probabilities" according to most direct sources.[Investopedia Subjective Probability](http://www.investopedia.com/terms/s/subjective_probability.asp)
* Another reason could be that investors know that, for some reason, if scenario I comes round they will be desperate for cash, but if scenario II comes round they will be rich from other income sources anyway. If that's the case then they are more *interested* in the value of the asset in scenario I than in scenario II. Then they value the asset as being worth, maybe,[(3/4)*(100) + (1/4)*(0)]/(1+r)=75/(1+r), because the Scenario I payoffs are worth more to them than the Scenario II payoffs.

In any case, if you observe the price to be 75/(1+r) then the numbers 3/4 and 1/4, which look like probabilities, are called the "risk-neutral probabilities". They are "weights" that look like probabilities, that describe two things: investor's subjective assessment of the likelihood of the two scenarios, plus the "importance" they put on different future states of nature, beyond the likelihood of their realization.

These risk neutral probabilities are at the core of the paradigm that economists use to model asset prices .

> **Comments:**
> **username_4**: This seems very inaccurate. It is the utility of the money that changes, not the perceived probability of the outcome.  
> **username_5**: OK. I'm positive this is how some people use these terms, but I can't find any references that say exactly that, so I think you are right, that this is not the most appealing interpretation of these terms. ... will rewrite.  

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