Even as S&P downgraded its credit rating for the US, there has been no evidence of a “flight to safety” that stock markets usually witness at the drop of a hat. After all, when safety of the so-called safest asset, the US treasury bill whose rate of return is often considered as the risk-free rate of return, itself becomes questionable, where do investors go?

The reaction of financial markets to the downgrade can be interpreted to some extent as throwing good money after bad, or perhaps lending more of your money only to keep your debtor afloat, so that at some point in the future, you can recover your first loan, your second and further loans, and interest on all of them. (This reminds one of how Ninja loans were built up to unsustainable levels in the US in the not too distant past.)

Prof. Jayant R. Varma of IIMA, as expected, has an interesting take on this issue – that US Treasury assets might be Giffen goods. Giffen goods, in economics, can be loosely defined as goods for which demand rises even as the price rises – which is the inverse of a typical demand curve.

<Alert: Jargon ahead!>

Prof. Varma explains that “in a pure mean-variance optimisation framework, [the US Treasury bill] can never be a Giffen good.” However, “in a more general expected utility setting, [it] can be a Giffen good.” In the former, for both low and high levels of risk tolerance, the investor will hold less of the safe (as compared to risky) asset when its risk level increases. Hence the safe asset is not a Giffen good.

Unlike this, in the latter case, the risk aversion increases as the risk level of the safe asset increases. This means that more of the safe asset will be purchased even as its risk level rises. Ergo, the Giffen good situation, which could explain investor reaction to the US credit rating downgrade. Prof. Varma’s subtle sense of humour also presents itself on occasion: “In keeping with the spirit of the times, the expected return on the safer asset is zero – instead of a risk free return, it represents return free risk.”

Having said this, my understanding of the field is limited. So if you have read on till here, it might be worth taking a look at the link cited earlier. The article is interesting, and not just for MBAs or the finance world.