Yesterday we saw large losses in stock markets all over the world. The correction followed suit in Asia this morning and the opening bell on Wall Street this afternoon (Swedish time) will be one of the more exciting sounds in memory….
A student asked me yesterday why we had these sudden stock price falls and I obviously had no simple answer to this. Instead I tried to give him an example from the credit world, a world that is just one of many markets I have thought for a long time is overvalued. I asked him if he would choose to buy a corporate bond from a big firm with high credit rating at 3.2% annual interest or put the money in a safe government bond (or deposit insured bank account) giving 3% annual interest. He said he would have chosen the latter considering the large unexpected (tail) risk in the former. That’s exactly my point; only people playing with other people’s money (with limited liability) are prepared to go for the corporate bond in the example above. And unfortunately there are too many of these out there. I see this as one explanation for the recent corrections in various markets; that people finally start getting the point! Kuro no Keiyakusha!
