15/12/2019 Risk Neutral Definition

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Risk Neutral
REVIEWED BY GORDON SCOTT, CMT | Updated May 1, 2019

What is Risk Neutral?

Risk neutral is a concept used in both game theory studies and in finance. It refers to a
mindset where an individual is indifferent to risk when making an investment decision. This
mindset is not derived from calculation or rational deduction, but rather from an emotional
preference. A person with a risk-neutral approach simply doesn't focus on the risk--
regardless of whether or not that is an ill-advised thing to do. This mindset is often
situational and can be dependent on price or other external factors.

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KEY TAKEAWAYS
Risk neutral describes a mindset where investors focus on potential gains when
making investment decisions.
Risk neutral investors may understand that risk is involved, but they aren't
considering it for the moment.
An investor can change their mindset from risk averse to risk neutral.
Risk-neutral measures play an important part in derivatives pricing.

Understanding the Concept of Risk Neutral

Risk neutral is a term used to describe the attitude of an individual who may be evaluating
investment alternatives. If the individual focuses solely on potential gains regardless of the
risk, they are said to be risk neutral. Such behavior, to evaluate reward without thought to
risk, may seem to be inherently risky. A risk averse investor would not consider the choice to
risk $1000 loss with the possibility of making $50 gain to be the same risk as a choice to risk
only $100 to make the same $50 gain. However someone who is risk neutral would. Given
two investment opportunities the risk-neutral investor only looks at the potential gains of
each investment and ignores the potential downside risk.

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Risk Neutral Pricing and Measures

There could be any number of reasons why an individual would reach a risk-neutral mindset,
but the idea that an individual could actually change from a risk averse mindset to a risk-
neutral mindset based on pricing changes then leads to another important concept: that of
risk-neutral measures. Risk-neutral measures have extensive application in the pricing of
derivatives because the price where investors would be expected to exhibit a risk-neutral
attitude should be a price of equilibrium between buyers and sellers.

Individual investors are almost always risk averse, meaning that they have a mindset where
they exhibit more fear over losing money than the amount of eagerness they exhibit over
making money. This tendency often results in the price of an asset finding a point of
equilibrium somewhat below what might be accounted for by the expected future returns on
this asset. When trying to model and adjust for this effect in marketplace pricing, analysts
and academics attempt to adjust for this risk aversion by using these theoretical risk-neutral
measures are.

For example, consider a scenario where 100 investors are presented and accept the
opportunity to gain $100 on if they deposit $10,000 in a bank for 6 months. There is virtually
no risk of losing money (unless the bank itself were in danger of going out of business). Then
suppose those same 100 investors are subsequently presented with an alternative
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investment. This investment gives them the opportunity of gaining $10,000, while accepting
the possibility of losing all $10,000. Finally suppose we poll the investors over which
investment they would choose and give them three responses: (A) I'd never consider that
alternative, (B) I need more information about the alternative investment, (C) I'll invest in the
alternative right now.

In this scenario, those who responded A, would be considered risk-averse investors, and
those who responded C would be considered risk seeking investors, since the investment
value is not accurately determinable with only that much information. However those who
responded with B recognize that they need more information to determine whether they
would be interested in the alternative. They are neither adverse to risk nor seeking it for its
own sake. Instead, they are interested in the value of expected returns to know whether or
not they prefer to take the risk. So at the moment they seek more information, they are
considered risk neutral.

Such investors would probably want to know what the probability of doubling their money
might be (in comparison to possibly losing it all). If the probability of doubling were only
50%, then they could recognize that the expected value of that investment is 0 since it has a
equal possibility of losing everything or doubling. If the probability of doubling were to shift
to 60%, then those who were willing to consider the alternative at that point, would have
adopted a risk-neutral mindset, because they were focused on the probability of gain and no
longer focused on the risk.

The price at which risk-neutral investors manifest their behavior of considering alternatives,
despite the risk, is an important point of price equilibrium. This is a point where the greatest
numbers of buyers and sellers may be present in the market.

Related Terms
Risk-Neutral Probabilities
Risk-neutral probabilities are the odds of future outcomes adjusted for risk, which are then used to
compute expected asset values. more

What It Means to Be Risk-Averse

The term risk-averse refers to investors who, when faced with two investments with a similar expected
return, prefer the lower-risk option. more

Prospect Theory
Prospect theory argues that if given the option, people prefer certain gains rather than the prospect of
larger gains with more risk. more
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Emotional Neutrality Definition

Emotional neutrality is the concept of removing greed, fear and other human emotions from financial
or investment decisions. more

Risk-Neutral Measures
A risk neutral measure is a theoretical measure of a market's risk aversion. more

Expected Utility Definition

Expected utility is an economic term summarizing the utility that an entity or aggregate economy is
expected to reach under any number of circumstances. more

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