It appears that in the last few years huge amounts of money (think trillions of USD) have been invested in versions of a simple trading strategy that holds stocks and bonds. Importantly, the proportion of the stocks in this strategy is NOT constant, but changes depending on the stock volatility: when volatility is low, this proportion is higher, when volatility is high, this proportion is lower. Sounds like a reasonable strategy that tries to control risk, right?

a.Some people argue that this strategy is one major reason for the meltdown in stock markets that we observed in the last few weeks. How can you defend such an argument?

b.In our class we mentioned another previously popular trading strategy which has been blamed for a severe drop in the stock market in the past. Which was that strategy? Can you see any analogies with the strategy described in this question? Please explain carefully. Use also the next page if you need.

Hint: We have mentioned several times in class that there is a negative correlation between stock returns and stock volatility, and it is particularly strong for stock market indexes and their volatility.