Risk Neutral

  

Categories: Metrics, Derivatives

See: Hedge Ratio. See: Portfolio Insurance.

Any investment (or any bet in a Vegas casino, for that matter) comes with two components: risk and reward. Reward represents the amount you can make. Risk represents a combination of the chances that you might lose...and the amount you could possibly lose in the process.

A risk-neutral investor ignores all that nasty risk stuff. They only focus on the reward. They might drop their entire wad on Red 23, because, at 36-to-1, it’s got one of the best payouts in the casino. Never mind that it only has a 1-in-38 chance of hitting. That kind of thinking is for losers. So says the risk-neutral better.

The concept of risk neutral is more of an academic contrivance than a Thing that exists in pure form in the wild. Most investors have some aversion to risk, otherwise they wouldn’t last long. But the concept has uses in fields of study like game theory.

Related or Semi-related Video

Finance: What is market risk?5 Views

00:00

Finance Allah shmoop what is market risk All right There

00:08

are a lot of risks when you invest money Two

00:10

of the most common categories are unsystematic risk And yes

00:13

of course systematic risk Also known as market risk Well

00:17

unsystematic risk refers to risks linked to a specific stock

00:21

or security So you buy shares in your dad's publicly

00:24

traded ice cream company and the company goes bankrupt Who

00:27

knew pork rind ice cream would prove so unpopular Who

00:30

knew well that's unsystematic risk You made a bad investment

00:34

and you paid for it by losing everything you invested

00:38

un systematically Well that's individual stock risk or in systematic

00:42

risk AII bad brain bad return What not all investments

00:45

do well In fact many of them do poorly even

00:47

for the best of investors So most professionals diversify their

00:50

eggs such that not all of them are invested in

00:53

one stock or one basket So that revolves around unsystematic

00:57

risk That is risk You can actually do something about

01:00

and improve your odds of being successful like by being

01:03

a good smart investor But then there's market risk which

01:07

just exists as a natural part of the risk world

01:10

For illustrative purposes You could choose to not take any

01:13

road risk Like when you drive on the roads Your

01:16

odds of being hit by some idiot texting his girlfriend

01:19

and not looking at the double yellow line are not

01:21

one in a good Gillian right You also have a

01:23

risk of a tire blowout or a tree falling on

01:26

you or skidding into a mailbox on that hill with

01:28

the gravel in the oil slick from the construction people

01:32

right Those are all quote market risks unquote of driving

01:35

So why do it Why drive Why not just stay

01:38

home Never leave the house get Amazon and door dash

01:41

and ups to take care of all of your needs

01:43

and never suffer the market risk of dying on the

01:46

road Well for some people this probably is a good

01:49

idea Well the same allegory lives in the stock market

01:52

When you invest in stocks odds are extremely high that

01:56

at some period while their value will go down maybe

01:58

a lot You can't head yourself against things like terrorist

02:01

attacks and natural disasters political upheaval and zombie apocalypses or

02:06

apocalypse side They say The zombie There's no real way

02:09

to protect yourself against market risk It's just systematic It's

02:13

part of the system Got it So there's no way

02:15

to deal with market risk other than for one thing

02:18

time Historically the stock market goes up over time Check

02:23

out this glorious chart running for one hundred years in

02:25

change for what the market is done without even calculating

02:28

the additional return from dividends distributed along the way Well

02:31

you can see that there has rarely been an extended

02:33

period of time when the market didn't go up and

02:36

or at least distribute enough in dividends Such that in

02:38

each decade while there's been a nicely positive return from

02:42

being invested in the stock market could this suddenly change

02:46

and go the other direction such that we have half

02:48

a century of no growth Sure but that would be

02:51

a big departure from the way our driving has gone

02:53

in the past on the roads But you never know

02:56

There's always the N plus one idiot out there texting

02:59

and driving and you know really not giving a

Up Next

Finance: What are Systematic and Unsystematic Risk?
14 Views

What are systematic and unsystematic risk? Take a risk on this video and hit play.

Finance: What is risk premium?
0 Views

What is risk premium? Risk premium is the amount of excess return or yield that a bond must pay in order to compensate for the additional default r...

Finance: What is a Risk Profile?
0 Views

What is a Risk Profile? A risk profile is an assessment of an individual’s or corporation’s tolerance for risks and volatility in making decisi...

Find other enlightening terms in Shmoop Finance Genius Bar(f)