Something to ponder over the weekend

A fantastic quote from mahalanobis:

There are a lot of talking heads saying that what is going on is a sane ‘repricing of risk’. It’s a cliche right now. But I don’t think investors are not so much re-evaluating the volatility or covariance of these assets, but rather re-evaluating the expected return. They are downwardly adjusting the expected forward payments independent of the discounting function, as the probability of default for sub-prime mortgages, or LBO’s, is being adjusted to more reasonable levels. Increasing the probability of default is not increasing risk so much as decreasing the expected return. They go together, of course, because higher default probability bonds have higher volatility too, but the expected return is the dog and the volatility of that return is the tail.


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