Financial instruments could be spiked with unfindable risks

December 21, 2009 by Steven Schultz, Princeton University
Financial instruments could be spiked with unfindable risks
Rong Ge, a graduate student in computer science, was part of a team that used intractability theory to study the pricing of financial derivatives. (Photo by Frank Wojciechowski)

(PhysOrg.com) -- In a result that may have implications for financial regulation, researchers from computer science and economics have revealed potentially impenetrable problems with the pricing of financial derivatives. They show that sellers of these investments could purposefully include pieces of bad risk that no buyer could detect even with the most powerful computers.

The research focused on collateralized debt obligations, or CDOs, an investment tool that combines many mortgages with the promise of spreading out and lowering the risk of default. The team examined what would happen if a seller knew that some mortgages were "lemons" and structured a package of CDOs to benefit himself. They found that the manipulation may be impossible for buyers to detect either at time of sale or later when the derivative loses money.

The team consists of Sanjeev Arora, director of Princeton's Center for Computational Intractability, his colleague Boaz Barak, economics professor Markus Brunnermeier, and graduate student Rong Ge.

It is now standard wisdom that a major culprit in the 2008 was use of simplistic mathematical models of risk at financial firms. This paper, released as a working draft Oct. 15, suggests that the problems may go deeper.

"We are cautioning that even if you have the right model it's not easy to price derivatives," Arora said. "Making the models more complicated will not make these effects go away, even for computationally sophisticated."

Arora noted that the problem arises from asymmetric information between buyers and sellers, and goes against conventional wisdom in , which holds that derivatives reduce the negative effects of such unequal information.

"Standard economics emphasizes that securitization can mitigate the cost of asymmetric information," Brunnermeier said. "We stress that certain derivative securities introduce additional complexity and thus a new layer of asymmetric information that can be so severe it overturns the initial advantage."

Brunnermeier noted that the finding came from combining computer science and finance, which has not been done before but has the potential for further insights. “I anticipate that both fields can enrich each other,” he said.

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Bob_B
1 / 5 (1) Dec 21, 2009
Is this different than while riding an elevator, someone (person A) overhearing an "insider" talking on a cell phone about information that Person A can benefit from if He/She acted on the information, i.e. bought stocks.

This is called Insider Trading. This can be very hard to detect, so the Feds throw a very large net to entrap anyone "near."
Blair
4 / 5 (4) Dec 21, 2009
... another sledgehammer science result.

Given the established cyber-casino,
run by the criminals taking over
the regulation of the casino,
being able to make money
to gamble with, out of
NOTHING, but faith
in social habits ...

and,

given derivative bets made with fiat money,
FOR SURE, there are going to be "risks"
that nobody can penetrate enough now.

That article seems like a bunch of jargon,
backed with its sledgehammer modelling,

to demonstrate that derivatives enabled
cyber-casino gambling that nobody can
understand nor predict all the outcomes.

The derivatives were derived from frauds.

Derivatives were frauds built on frauds!!!

Of course, they enable asymmetry between
the people running the cyber-casinos, and
those people who are forced to live inside.

"Combining computer science and finance"
is always going to be more manifestations
of the principle of garbage in, garbage out.
mattytheory
5 / 5 (1) Dec 22, 2009
Can someone please explain to me HOW leveraged assets can be further leveraged, as is the case with CDO's, and, WHY someone would buy such an asset?? Oh I get it, greed... and more greed. I think I read somewhere that greed begets greed but I am probably making that up.

Ok, seriously, someone help!
gwrede
1.5 / 5 (6) Dec 22, 2009
The good thing: this ought to give both investors and law makers something to consider.

The bad thing: heavy-duty mathematicians and computer scientists coming into financing. This will definitely widen the gap between those who can afford to buy better information and better tools, and those who don't.

Sadly, those who don't, are the regular people. And it's their money (their loans, investments) everybody else is playing with.
bobertjmurphy
5 / 5 (1) Dec 22, 2009
The bad thing: heavy-duty mathematicians and computer scientists coming into financing. This will definitely widen the gap between those who can afford to buy better information and better tools, and those who don't.


They've been there for over 20 years. On Wall Street, they're called "quants".

I started down that road about 1991, and bailed out after a couple of years for other areas of computer science. The folks running the show on the business side were naive and only wanted to hear what they wanted to hear, not the honest truth about what mathematical models could and couldn't do. It was clear to me a disaster or three were looming, and from both an ethical and practical perspective, I didn't want to be involved.
fmfbrestel
5 / 5 (1) Dec 22, 2009
"the finding came from combining computer science and finance, which has not been done before"

Yeah right... no one has used computer science to study finance before.... what kind of ignorant comment is that?
Arkaleus
2.5 / 5 (8) Dec 22, 2009
Seems like our confusion in money has its root in just a few fallacies:

1) Humans creating money at will can be trusted to never use this ability to their advantage;

2) Allowing some groups of people to create money at will and trade it secretly for profit will INCREASE the equality and liberty of the rest of the world;

3) There's nothing anyone can do about it.
VeIanarris
1 / 5 (5) Dec 22, 2009
I should also say that the best way out of the current mess is to adopt some of the methods learnt during my college days. I loved the simplicity that went beyond socialism, the brilliant but unattainable purity. Asthe maste himself said "Capital is money, capital is commodities. By virtue of it being value, it has acquired the occult ability to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs."
Caliban
2.3 / 5 (3) Dec 22, 2009
For as long as there are sufficient people to affirm and insist that Free Market Capitalism is the Natural Order of the Economy, and is the product of Darwinian evolutionary forces, and therefore a perfectly adapted organism, and beyond being interfered with, then there will ALWAYS be problems like this in both local and global economies. The fact is that they are not perfect, naturally arising environments. They are the constructs of human activity, and susceptible to manipulation.
The question that SHOULD be asked, is: "Where did those HUNDREDS of TRILLIONS of dollars go?"
I sure as hell don't have them. Do any of you guys? I didn't think so. Another question is: "What are you going to do with that money, now that you have it? You couldn't possibly spend it all, especially since you're not gonna buy everyone new shoes!"
And the very best part of all this is that WE- as in TAXPAYERS- are left with this ticking time bomb sitting in our laps. Crisis is not over, people.
Caliban
1 / 5 (2) Dec 22, 2009
I won't presume to speak for the rest of you- especially since some of you would most certainly disagree- but I have some profound difficulties with the notion of a system wherein those at the top are allowed to just reach in and grab whatever they want whenever they want, with the full force of Government and weight of Law(not to mention about half of "Public Opinion") to assist them- especially if there is any resistance. This is nothing less than thievery, perpetrated by a relative few, and abetted by the very government that most of us elected thinking that it was supposed to prevent the very thing. It is hard for me to accept that people sit around and (sometimes pretend to) scratch their heads and say that they just don't understand how or why this could happen. There is no mystery whatsoever.
@Arkaleus- very succinct. I felt the need to embelish.
Caliban
2 / 5 (3) Dec 22, 2009
No, the debt is still sitting there- for us to pay off.
Here's an example for you. If I bundled 500 million dollars worth of sub-prime mortgages into a "complex derivative" security, do you think I sold it to a "consumer" with out getting any cash in exchange for it?
These, and many other types of similar transactions are what vacuumed all of that available cash out of our- and therefore the rest of the world's- economy. Again I say, the question that you should be asking is: Where did all that money go?"
Caliban
1 / 5 (2) Dec 22, 2009


@otto-
Agreed. If you're not in a position-pretty much from the outset- to be able to take advantage of the protections(all for the benefit of those at the top of the pyramid)that are built into the system, then you are basically just a crop to be harvested.
When you hear the phrase "growing wealth" you can interpret it in the literal sense, because unfortunately, you run the very real risk of "growing" it for someone else.

Arkaleus
1.7 / 5 (6) Dec 22, 2009
For any adult to consider themselves matriculated in reality they should be able to fearlessly model the power structure of the world. They choose early in life which of those powers to join.

Those who have elected the power of liberty and uprightness know that paper money is the weapon of bloodless global conquest, and it is used against us at home as well as others abroad. They all know the moneyprinters have used this weapon of mass delusion and ensnared us in a diabolically engineered scheme.

When considering the United States, the sightful eye sees the warning of Andrew Jackson emerge from the abominable dreams of our forefathers into living flesh as the Federal Reserve, IMF, and World Bank.

When these power groups succeed in consolidating the available capital of the world, their rule will be absolute - unless something happens that is against the "rules".

Fallacy #3 need not be bloody, Velanarris. Banksters are weak, and no one will die for them.
stealthc
1 / 5 (5) Dec 23, 2009
We should hang the people that made derivatives a reality for high treason. They are murderers just like saddam and osama are. Putting financial squeeze on people, sometimes extreme enough to starve people to death. These people are bigger murderers than even stalin was.
VeIanarris
1.9 / 5 (8) Dec 23, 2009
You have to say that capitalism, the creation of wealth from 'thin air' has plunged us into a sea of debt. never before has so much, of nothing, been owed to so few by so many.
As Karl Marx said "Democracy is a form of government that cannot long survive, for as soon as the people learn that they have a voice in the fiscal policies of the government, they will move to vote for themselves all the money in the treasury, and bankrupt the nation."
ForFreeMinds
1 / 5 (7) Dec 24, 2009
What's the point of applying mathematical models to derivatives if "a seller knew that some mortgages were 'lemons' and structured a package of CDOs to benefit himself"? Why is it that there isn't an incentive for the rating agencies to investigate the soundness of underlying mortgages when rating the CDOs? An account would at least investigate a sample. Seems obvious the implicit guarantees offered by the US Govt. removes the need.

What's the "standard wisdom"? That "a major culprit in the 2008 financial meltdown was use of simplistic mathematical models of risk", or perhaps beware of politicians and the PhDs who receive govt. blaming others for their immoral activity.
Husky
not rated yet Dec 26, 2009
if you wrap a turd in enough paper nobody will smell it, thats why we should limit derivatives in the first place
Paul123
Dec 26, 2009
This comment has been removed by a moderator.
GrayMouser
1 / 5 (4) Dec 27, 2009
As Karl Marx said "Democracy is a form of government that cannot long survive, for as soon as the people learn that they have a voice in the fiscal policies of the government, they will move to vote for themselves all the money in the treasury, and bankrupt the nation."

Marx was quoting someone else, if not an earlier Greek writer then Alexander Tyler in 1787:
THE FALL OF THE ATHENIAN REPUBLIC... "A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse over loose fiscal policy, (which is) always followed by a dictatorship."
GrayMouser
1 / 5 (4) Dec 27, 2009
To complete the line of thought, Marx could not understand two things:
1) that the ruling class wants to remain the ruling class and will twist the system to keep their children in the ruling class.
2) if everybody is paid the exact same thing regardless of the work performed there is no reason to excel, because there is no rewards.

All of the so called Communist countries in the 20th century were in fact dictatorships with superficial Marxist guise. That's one of the reasons the USSR was referred to as Marxist-Leninism instead of Marxist.
CaptBarbados
not rated yet Dec 27, 2009
The American economy represents 1/3 of the World's GDP. Wall Street peed on a LOT of boots besides the American taxpayer.

I'd suggest a review of deregulating the ability to combine banking services, as has been done this past two decades.

That has failed.

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