Riskneutrality

Riskneutrality is a concept used in finance and economics that describes a hypothetical investor's attitude towards risk. A risk-neutral investor is indifferent to risk. This means that they would accept a gamble with an expected monetary value equal to a certain outcome. For instance, if offered a choice between receiving $100 for sure or a 50% chance of receiving $200 and a 50% chance of receiving $0, a risk-neutral person would be equally happy with either option because the expected value of the gamble is $100.

The concept of riskneutrality is particularly important in option pricing models, such as the Black-Scholes model. These models assume that investors are risk-neutral to simplify calculations. While real-world investors are typically either risk-averse (preferring a certain outcome over a gamble with the same expected value) or risk-seeking (preferring a gamble over a certain outcome), the risk-neutral framework provides a convenient mathematical tool. It allows for the calculation of an asset's fair price by abstracting away from the investor's specific risk preferences. The actual price in the market may then differ from this theoretical price due to the presence of risk premiums or discounts reflecting aggregate market risk attitudes.