Risk neutral

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In economics, risk neutral behavior is in between risk aversion and risk seeking. If offered either €50 or a 50% chance of €100, a risk averse person will take the €50, a risk seeking person will take the 50% chance of €100, and a risk neutral person would have no preference between the two options.

In finance, when pricing an asset, a common technique is to figure out the probability of a future cash flow, then to discount that cash flow at the risk free rate. For example, if the probability of receiving $1 one instant from now is 50%, the value is $0.50. This is called 'expected value', using real world probabilities. Risk neutral demonstrates that when pricing some assets, the real world probabilities assigned to future cash flows are irrelevant.

The fundamental assumption behind risk-neutral valuation is to use a replicating portfolio of assets with known prices to remove any risk. The amounts of assets needed to hedge determine the risk-neutral probabilities.

See also

• Risk neutral valuation
• Risk-neutral measure