I still have a hard-time figuring out what has the person who defaulted on his mortgage got to do with stocks every where in the world. The mortgage defaulters are “sub-prime” or is a person with high chance of default. Yet, the defaulters are causing rampage throughout the eco-system. Now that the Central banks around the world are conducting open market operations to maintain sanity in the finance system, does it mean we are truly in a crisis already?

These days, many lenders have become risk-adverse. Requiring more stringent borrowing requirements are a higher interest rate to compensate for a perceived higher risk. Lenders don’t trust borrowers now. Reputable banks are now tainted with large losses due to them holding large amount of CDOs. All this means is that the cost of borrowing has increased. This is bad for business as there is a lower amount of available money to fund expansionary purposes for companies and the economy as a whole.

Central banks manage their economies either through fiscal policy or monetary policy. The objective is the same which is implement an expansionary or contractionary policy.  Fiscal policies are like changes in tax rate and public spending. Monetary policies are like adjusting for reserve requirement in the banks, discount rate or open market operation. For the past 1 week, Central banks around the world had been involved in open market operation. This is done by buying T-bills or government bonds from the market. In doing so, the Central banks are effectively injecting money into the system. This increases money supply and thus decrease the cost of borrowing (Economics 101: When supply increases faster then demand, the cost of goods/services decreases). The monetary policy is expansionary.

What is of concerned is the simultaneous open market operations done by major central banks. This is not a good news because it means that the global market is experiencing the same problem. Having a problem that affects the entire market is known as systematic risk. Such risk affects all markets and all companies. This is what we are experiencing now. Other examples of systematic risk are 911 terrorist attack, SARS and fears of interest rate hike (during May 2006). Non-systematic risks are those that affect certain individual companies such as fraud, mismanagement and insider trading. Non-system risks can be eliminated through diversification. Research has shown that systematic risk is worth taking. It does comes with a corresponding reward. On the other hand, non-systematic risk is non-rewarding.

Therefore, for those with diversified portfolio can be assured that it only has systematic risk and should find comfort that such a risk is rewarding. The only problem is that most people don’t know how to construct a diversified portfolio. Give your comments