02 October 2008

Risk Aversion

In general, the higher the risk of an investment, the higher the expected return demanded by an investor. Readers familiar with the capital asset pricing model will know that there are two types of risk in the economy: systematic and nonsystematic. Nonsystematic risk should not be important to an investor. It can be almost completely eliminated by holding a well-diversified portfolio. An investor should not therefore require an higher expected return for bearing nonsystematic risk. Systematic risk, by contrast, cannot be diversified away. It arises from a correlation between returns from the investment and returns from the stock market as a whole. An investor generally requires a higher expected return than the risk-free interest rate for bearing positive amounts of systematic risk.

John C. Hull, Options, Futures and Other Derivatives, fifth edition, p.61



One quibble I have with a lot of the discussion of mortgage investments (such as this one, which I think is otherwise very good), is that it seems to offer a choice between two possibilities:

1) The current market prices of the securities correctly reflect their expected return

2) The securities are currently undervalued due to panic or other irrationality

I am fairly confident that neither of these positions is correct. Risk aversion is not irrational. If an investor loses more than he can afford to lose on one investment, that loss will itself cause secondary losses — if the investor is an institution, it might lose its credit rating, or go insolvent, causing some of its human and institutional capital to be impaired. Therefore, the expected utility of an risky investment is lower than its expected return.

As alluded to by Hull, in many cases much or all of the risk of an investment can be diversified away, leaving the extra risk premium small or zero. This is clearly not the case for mortgages. There is a possibility of a loss of somewhere on the order of a trillion dollars. No investor can absorb or hedge that. Many large investors — sovereign wealth funds, private equity, etc. -— have taken on stakes. Some are probably still looking for better prices than they've so far been offered. All will be looking for very substantial discounts against the expected return, because they know there are more sellers than buyers.

That is why I believe claims that this is a profit opportunity for the government.

That's not the same as saying the government should be buying up mortgages at above current market value — there are other good arguments against it. But it holds up one piece of the argument, provided we assume that government is in fact better able to absorb the potential losses than private investors, which seems reasonable to me, though I can't quite put my finger on a non-handwavy reason why.

1 comment:

Aaron Davies said...

"...this technology, called a printing press..."?