Risk Neutrality and Arbitrage-Free Pricing

In the context of derivative contracts, which of the following is _least likely_ to be a part of the arbitrage-free pricing process?

Incorrect. This is the essence of arbitrage free pricing. Because it is possible to profit from mispricing of derivatives without assuming any risk, traders will conduct such arbitrage transactions until no arbitrage opportunities remain.

Incorrect. The establishment of arbitrage free price depends on the ability of traders to conduct profitable trades without taking any risk when a derivative is mispriced. Risk neutral hedges allow for such trades.

Correct! Because derivatives are priced based on arbitrage of risk neutral hedges, risk premiums have no role in their pricing. Risk aversion and the consequent risk premiums may be important in pricing the asset underlying a derivative. However, once the underlying asset's price is known, risk premiums have no role in determining the derivative's value.

Risk-free arbitrage is possible whenever a derivative is mispriced

Risk neutral hedging is made possible by combining derivatives with their underlying

Investors' risk aversion determines the risk premium used to discount the derivative's cash flows