From a finquiz answer:
“For the forward rate to be an unbiased predictor of the expected spot rate, both covered and uncovered interest parity must hold. For uncovered interest rate parity to hold, investors must be risk neutral”
Does risk neutral mean that everyone chooses to avoid any undue risk? “Risk Neutral” is used in many contexts in this curriculum so would like to know what people’s definitions for it is.
Risk neutral simply means that we’re discounting these values using the risk-free rate; we don’t add any risk premium.
At least, that’s how CFA Institute describes it in footnote 23 on p. 176 of v. 6.
Thanks S2000, how do you think that relates to the uncovered interest rate parity?
Uncovered interest rate parity holds when currencies grow at their risk-free rates: no risk premia.
UIP suggests that the expected exchange rate is sustained by the spread between both countries’s yield, and as a result, gains cannot be made through “carry trading”, since the ER will move depending on this spread to rebalance. The investor becomes risk neutral at that point