M & A Law Prof Blog

Editor: Brian JM Quinn
Boston College Law School

Tuesday, November 3, 2009

Derivatives, Complexity, and Asymmetric Information

Arora, et al have a paper, Computational Complexity and Information Asymmetry in Financial Products, which concludes that the complexity of financial derivatives due in part to the complicated structure of many derivatives, the sheer volume of financial transactions, the need for highly precise economic modeling, the lack of transparency in the markets increases information asymmetries rather than decreases them.  I made a similar argument in a paper, The Failure of Private Ordering and the Financial Crisis of 2008, last Spring, but minus all of the horsepower these guys bring to the table.

Abstract: Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to and buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.




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