Abstract
Abstract We review the valuation of uncertain future cash flows. This article has a history of several centuries in the actuarial literature as well as in Bachlier's “fundamental principle” for the valuation of options. The technique, which is a basic tool in mathematical finance, consists in calculating the expected value of the discounted cash flows. The crucial point is that we calculate this expectation under a so‐called “risk neutral” probability measure. In the context of the Black–Scholes model, the risk neutral measure is the unique probability measure which is equivalent to the given “physical” or “historic” probability measure and under which the discounted stock price process is a martingale.
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