Tuesday, August 09, 2011

Realignment: Ratings and relative risk stack

Investors think of risk associated various assets (across classes) in relative terms. We have a notional relative assessment - A is riskier than B but C is more risky than A etc. This applies to asset classes and specific assets within them. So Manhattan land parcel may be riskier than NY state debt etc.

Thus, we have a stack of assets. We can imagine this as a deck of cards that the investor carefully aligns according to their risk profiles. On one side, lets say the bottom of the deck of cards, we have less risky and they get progressively more risky as we reach the other end, i.e. the top.

The S&P ratings change signals a change in the order of this stack - sort of shuffling of the cards. Some investors believe that shuffling happened a long time ago and S&P is just highlighting it. Others believe there has been no shuffling of the deck and previous order remains valid.

In essence, each investor is making his or her own assessment. We are all on our own.

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