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6.2. RATIONAL RISK PREMIA 175µ t+1 is low when consumption growth is high. What it boils down to isthis. Holding the euro forward pays off well in good states of the worldbut you don’t need an asset to pay off well in the good state. You wantassets to pay off well in the bad state—when you really need it. But theforward euro will pay off poorly in the bad state and in that sense it isrisky.h iIf the euro is risky the dollar is safe. If EFt −S t+1t P t+1< 0andyoubuy the dollar forward, you expect to realize a loss. It might seemlike a strange idea to buy an asset with expected negative payoff, butthis is something that risk-averse individuals are willing to do if theasset provides consumption insurance by providing high payoffs inbad(low growth) consumption states. The expected negative payoff can beviewed as an insurance premium.To summarize, in Lucas’s intertemporal asset pricing model, therisk of an asset lies in the covariance of its payoff with something thatindividuals care about—namely consumption. Assets that generate highpayoffs in the bad state offer insurance against these bad states and areconsidered safe. A high payoff during the good state is less valuable tothe individual than it is during the bad state due to the concavity ofthe utility function. Risk-averse individuals require compensation byway of a risk premium to hold the risky assets.Risk-neutral forward exchange. If individuals are risk neutral, the intertemporalmarginal rate of substitution µ t+1 is constant. Since thecovariance of any random variable with a constant is 0, (6.13) becomesà ! à !Ft St+1E t =E t . (6.14)P t+1 P t+1So even under risk-neutrality the forward rate is not the rationallyexpected future spot rate because you need to divide by the futureand stochastic price level. To see more clearly how covariance risk isrelated to the fundamentals, it is useful to take a look at expectednominal speculative proÞts.