CFA CFA Level 2 How does unbiased expectation theory assumes risk neutrality?

How does unbiased expectation theory assumes risk neutrality?

  • This topic has 1 reply, 2 voices, and was last updated Oct-20 by rollover2.
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    • rohitkrsingh2000
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      In CFA material it is mentioned Unbiased expectation theory is consistent with risk neutrality, can someone explain how? Example will be useful.

    • rollover2
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      This might be cultural differences, but just FYI your question came across to me as very entitled. You’ll get a better response to your questions if you ask clearly, maintain politeness and help others in the forum when you can.

      But I’m nice, heh. So here goes:

      The unbiased/pure expectations theory assumes that current long-term interest rates can be used to predict future short-term interest rates. So this means that instead of purchasing one three-year bond, an investor may buy:

      a one-year bond now and another two-year bond later, ora two-year bond now and another one-year bond later.

      According to the unbiased expectations theory, the returns should be identical in all 3 cases, i.e. for a given holding period, the average expected annual yields on all combination of maturities will be equal.

      However, for this theory to work, one of the main assumptions is that investors are indifferent between owning a single long-term security or a series of short-term securities over the same period, i.e. risk neutrality. So, risk neutrality implies that all investors are indifferent to interest rate reinvestment risk, and that investments of different maturities are perfect substitutes for each other.

      But in reality, it is unlikely the case. But that’s another story.

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