Princeton Economist and Computer Scientists Show that Derivatives Are Inherently Vulnerable to Fraud

(WashingtonsBlog) – As I have previously noted, credit default swaps are destabilizing for the economy. See this. And the models used to evaluate financial instruments – such as the Gaussian copula formula for CDOs – are inherently flawed.

Now, Princeton University economists and computer scientists have demonstrated that financial derivatives are also inherently vulnerable to fraudulent pricing.

PhysOrg summarizes Princeton’s findings:

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
computer science graduate student Rong Ge.

It is now standard
wisdom that a major culprit in the 2008 financial meltdown 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 economic theory, 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.

Source: Washingtons Blog