Derivatives 101: 5

There are a number of principles that people tend to employ when trying to understand financial markets -- and in particular to value financial instruments -- that are, basically, wrong. Of course, that's not unique to finance, or even unusual. Most intellectual analysis requires approximation, because the world is elbow-deep in unbelievably complex (and often not very interesting) dirt; glossing over which can turn an intractable problem into one for which it may be possible find a solution, however approximate. All fair enough, as long as we acknowledge the approximation. Perfect, clean, unproblematic answers are the territory of blind faith, not rational enquiry; and we know how that turns out.

All the same, it would be easy to balk at some of the axioms of derivatives pricing... were it not for the fact that the markets are an exercise in collective fiction whose authors are mostly working to those same axioms. The more abstracted securities become, the more likely it is that those trading them will understand them in terms of shared abstractions, and behave as if those abstractions were real, and thereby make them so. It is a self-fulfilling fallacy.

Make no mistake: the resulting fictions are utterly real. They shape the world. They build, pollute, sustain and kill. In all likelihood you owe your livelihood to them; your home; your trinkets; your debts. The stories whispered in the eyries of high finance echo down to the gutters we inhabit, and we live and die by them.

Here's one of those stories: markets are efficient. That is, there are no hidden costs or hidden knowledge. There are no barriers to trade, no secrets and no lies. Everyone involved behaves rationally and their only motivation is the pursuit of profit. Every purchase or sale is driven by what people know and what they want and who they are and how they think things work, and all this information accumulates in the fluctuations of price. Consequently, the state of the market is an accurate and detailed portrayal of the state of the world; albeit a rather autistic one.

Taken at face value, this is clearly bollocks. Oh, it is surely safe to trust in the avarice and venality of those involved; but the free flow of knowledge and profit are different matters altogether. Not for nothing is the news regularly full of corruption scandals, cartels and insider dealing. The ones we hear about are those who get caught misbehaving, but they are not exceptional. Whole swathes of the finance industry are devoted to finding and exploiting market inefficiencies by any means necessary.

Adherents of the efficient market hypothesis would argue that to be hung up on such details is to miss the wood for the trees: in the long run, that kind of local inefficiency is just statistical noise. It must always even out. Markets are like Seurat paintings: you need to take a step back and appreciate the bigger picture, or else get lost among the dots.

Not only that: all those ravening sociopaths poised to pounce on any tiny pockets of inefficiency and tear them into bloody shreds of profit are, themselves, nothing more than the benign agents of market efficiency. Their feeding frenzy reintroduces the information whose absence gave rise to the momentary distortion in the first place; their trading restores the natural equilibrium.

This process has a name: arbitrage. Which means, in the most limited sense, buying and selling the same thing in different markets to realise a risk-free profit; but can be taken more broadly to represent any exploitation of pricing differences, including those of derivatives.

(ISTR that Richard Gere's character in Pretty Woman was an arbitrageur; a profession chosen, undoubtedly, as character shorthand to signify all that is most reprehensible and morally bankrupt in humanity -- in contrast to Julia Roberts' life as a prostitute, a selfless and giving vocation.)

One of the main arguments for pricing derivatives -- which in this context is pretty much synonymous with understanding them -- is that arbitrage is untenable. Not actually impossible, since these situations demonstrably do arise, but, given a plausibly large body of people intent on exploiting them, so transient and unlikely as to be negligible.

So: smooth out the exceptions, focus on the signal. What does it say?

Even if we pretend that all the assumptions about information and behaviour and the mechanics of the market are true, even if the pointillist self-portrait thereby painted is utterly perfect, it is still pretty fucking lopsided. Who, after all, is holding the brush? Who is looking in that mirror?

I know it's not me; I'm pretty certain it's not you; and for that matter it's not Adam fucking Smith...
Posted by matt at February 24, 2006 11:06 PM