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

As I have previously noted, credit default swaps are destabilizing for the economy. 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.

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  • http://www.blogger.com/profile/02345893660115107054 Knute Rife

    As I've said a pile of times in a pile of places, a CDS is an insurance policy treated like a security. We do not allow trading of insurance policies because such activity is an inherent gaming of the system, a fact we have known for over 200 years. A fact we chose to ignore in this instance, with inevitable results.

  • http://www.blogger.com/profile/13156080225918567393 The Grey Tiger

    Wasn't it the same dudes who thought they could beat the market with their math models in the first place?Until they make them totally illegal they will be a ticking time bomb. The Carbon model is just sitting out there waiting to become law and away we go again. Doing away with them is the only answer.

  • http://Anonymousnoreply@blogger.com Anonymous

    Thanks for that -don't mind if you shut the door since the horses are already 10miles downstream?Ta.

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