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What is Risk Neutral?

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  • Written By: Toni Henthorn
  • Edited By: W. Everett
  • Last Modified Date: 26 September 2016
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Investors fall into three broad categories with respect to the relative degree of risk they are willing to tolerate in their investment strategies. Risk neutral investment involves decision-making that does not take into account the risk of the investment. Most investors are risk-averse, choosing the lowest risk investment that yields a given rate of return. On the other hand, risk seekers engage in high-risk investments, with low potential payoffs or a low probability of making a profit. Risk neutral investors consider other parameters than risk, such as rate of return and market momentum, when choosing securities for investment.

For example, imagine three investors each have $1,000 U.S. Dollars (USD) to invest. The risk-averse investor chooses to put his $1,000 USD in a United States Treasury bond with a three percent rate of return. Attracted to risk, the risk seeker invests his money in a start-up company that sells the latest enhancement product online, with a potential rate of return of five percent. Although a stock purchase involves more risk than that of a Treasury bond, the risk neutral investor elects to buy stock hopefully in order to earn a higher rate of return than three percent.

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The phrase risk neutral has also been applied to specific options strategies in which the risk of holding positions in stocks is mitigated by offsetting call and put options. For example, conversion arbitrage is an investment strategy in which the investor holds a position in a stock while selling a call option and buying a put option with the same strike price. The investor attempts to execute the options so that the premium of one or the other option exceeds its market value throughout the duration of the conversion arbitrage. In other words, a long stock position is hedged with a short call and a long put with the same strike price, theoretically locking in a profit and making the strategy relatively risk neutral.

For example, imagine XYZ stock sells at $74.20 USD. In a given month, the call option sells at $4.90 USD and the put option for $5.70 USD. A conversion arbitrage can be set up for $75.00 USD, with a strike price of $76.00 USD for both options. At the current price, the time value for the short call is $4.90 USD with an intrinsic value of zero, and the time value for the long put is $4.70 USD with an intrinsic value of $1.00 USD. The net time value is $0.20 USD, which means a 20-cent net time-value credit per share.

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