Definition of 'Risk Neutral'
Risk neutrality is a useful assumption in many financial models, as it allows for a more tractable analysis. For example, the Black-Scholes model for option pricing assumes that investors are risk-neutral. This assumption allows the model to be solved for the fair price of an option, without having to take into account the investor's risk preferences.
There are a number of reasons why an investor might be risk-neutral. One reason is that the investor may have a large enough portfolio to diversify away all of their risk. Another reason is that the investor may be using derivatives to hedge their risk. Finally, the investor may simply be indifferent to risk.
It is important to note that risk neutrality is just an assumption. In reality, most investors are not completely risk-neutral. However, the risk-neutral assumption can often provide a good approximation of the behavior of real investors.
In the context of portfolio theory, risk neutrality is a property of an investor's utility function. A risk-neutral investor is indifferent to the riskiness of their portfolio, and only cares about the expected return. This is in contrast to a risk-averse investor, who would prefer a portfolio with a lower risk and a lower expected return to a portfolio with a higher risk and a higher expected return.
The risk-neutral measure is a probability measure that is used in the pricing of derivatives. It is the measure that would be used by an investor who is indifferent to risk. The risk-neutral measure is often used in conjunction with the Black-Scholes model to price options.
In conclusion, risk neutrality is a useful assumption in many financial models. It allows for a more tractable analysis and can often provide a good approximation of the behavior of real investors.
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