
Intractability of Financial Derivatives - oscarwao
http://www.freedom-to-tinker.com/blog/appel/intractability-financial-derivatives
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biohacker42
This is interesting, but I'm struck by the sheer amount of serious analysis on
this topic. It always struck me as very simple requiring no deep
understanding.

There's an old saying on wall street, the harder it is to understand the deal
the bigger the profit. The truth of this should be self evident. Add to that
the fact that the people gambling weren't gambling with their own money. That
way if they won then got big bonuses, and if they lost they simply didn't get
bonuses. Clearly the only rational action in this situation is to go all in
with other people's money.

Is it really that complicated? You wouldn't give your money to someone else
and send them to Vegas, tell them to gamble if they win you split the profits,
if they lose you lose your money.

You shouldn't invest in things you don't understand, and mind that old wall
street saying.

But people do invest in things they don't understand, and pyramid schemes, and
tulips, none of this is new. Sure some fancy math was involved this time, but
that's only tangential.

I think everyone is concentrating on the fancy math because it's like magic,
and then it's not their fault, it's not the same old story of everyone just
being stupid again like in .COM 1.0, oh no - It's _magic_!

~~~
kurtosis
Yeah I think you're totally right on here. I would go even further and suggest
that these pseudo-scientific valuation models were cynically exploited to make
it sound like the risks were calculable.

I think an analogy to medicine is appropriate - for many years the desperation
and naivete of the sick was exploited by frauds selling patent medicines. Many
makers of these bogus cures undoubtedly sincerely believed in their efficacy.
Watching this history would make you suspicious of anyone who claimed that
they could cure your illness with a drug. Despite this sordid reputation,
there really are wonder drugs. If medicine can be made scientific so can
finance.

~~~
joe_the_user
_If medicine can be made scientific so can finance._

Uh, one thing to be careful with in such a statement is reasoning by analogy.

Consider if someone says:

 _"If physics can be made scientific, so can pertual-motion-machine-
construction"_

Or

 _"If chemistry can be made scientific, so can alchemy!"_

Or

 _"If astronomy can be made scientific, so can astrology!"_

The problem is clearer. Not every "field" is subject to valid innovation since
some fields are inherently bogus. It is a hard problem determining _which_
fields can "scientifized" so you might not be wrong. But I personally think
that the real scientific _economists_ are those that have argued that you're
not ever going to find a "financial innovation" which adds value to the
economy as a whole.

~~~
dantheman
In fact the mere problem of discerning pseudo-science from science is almost
impossible by an fixed criteria.

~~~
kurtosis
Not sure what you mean by fixed-criterion How about about just demanding
falsifiable predictions, and doing experiments to test them?

~~~
dantheman
Most people think astrology is bunk science, but they can make predictions and
do experiments.

Throughout history physics has had experiments whose results were incompatible
with current models, which eventually lead to new theories (relativity, etc)
but how do you know when contradicting information disproves your theory or
will expand it.

~~~
roundsquare
I think we have an issue of defining pseudo-science here.

Definition 1: A field that can't be can't make falsifiable predeictions. By
this definitino, astrology is certainly a real science.

Definition 2: A field that makes false predictions. By this definition, most
peoplle thing astrology is a pseudo-science.

~~~
dantheman
Definition 2 is a flawed definition, perhaps some parts of astrology are
wrong, but some parts of physics are wrong, we just need more time to work out
the bugs in astrology -- more experiments need to be made.

If you're interested in this problem, this is a great reference:
<http://plato.stanford.edu/entries/pseudo-science/>

~~~
khafra
I think when your model consistently gives results indiscernable from random
noise in its strongest application (cf. blog.okcupid.com), you can safely
conclude that it's of no more value than a model selected at random from all
possible models of similar complexity.

------
frig
Economics as it is got going well before complexity theory was established.

There's an interesting difference between assuming perfect information and
perfect rationality -- idealizations of existing scenarios -- and essentially
assuming P=NP; the former makes the math easier at no real penalty (provided
you remember not to confuse the map with the territory) but until P is proven
to be equal to NP (which probably won't happen) the latter is more like
sprinkling pixy dust to make it go.

The only school that really takes something like tractability seriously are
the Austrians, but their math phobia leaves their approach unrigorous and not
very useful outside of as an anti-central-planning argument.

The claim that a market will converge on an accurate price (!) for an
"intractable" financial asset is pretty dubious; the price-discovery process
is supposed to depend on lots of agents running their #s and taking positions
depending on if they think current price is different than it ought to
be...over time this process will push the market price toward an accurate
price.

In the case of an intractable asset there'd be no reason to believe that any
outside agents crunched accurate #s, which means that even if the price
converged there'd be no reason to believe that the converged-to price had any
accuracy, which isn't usually the case in most other classes of financial
assets.

As noted towards the end they need to do some work about estimating "lemon
cost" and otherwise establishing how close you can estimate with approximate
methods.

(!) In general there's not much sense in talking about true or accurate prices
for some good; price is what it gets, full stop.

In the case of most financial products the notion of accurate price is more
justified: a product entitles the owner to some sequence of future cash flows,
which can be assigned a value in some straightforward manner. When a financial
asset's current price deviates from the value of the underlying sequence of
payments in some substantial way it's usually due to some easily-understood
dynamic (eg: inflation expectations, doubts about some of the payments coming
through) which makes a minor correction to the price it fetches.

An "inaccurate price" would be one with no apparent relation to the underlying
cash flows.

~~~
joe_the_user
_In general there's not much sense in talking about true or accurate prices
for some good; price is what it gets, full stop._

Well, if the price is not above the costs of production, you're going to have
a hard finding the product in stores for very long. Oppositely, the price and
availability of food, say, isn't at a certain level, the whole society may
cease to function.

While arguments about intractability, chaos and uncertainty are great and
interesting, it's worth considering that if an economy doesn't have a number
of important, predictable elements, things stop working.

------
kurtosis
I know that prof. Appel is a really smart guy from reading his books on
optimizing compilers - so I'm going to risk looking like an idiot here,
especially because I don't have time to carefully read the paper.. but maybe
someone can help me out here.

so he says that a buyer cannot determine that a CDO has been maliciously
packed with bad assets because this is equivalent to finding the densest
subgraph. Is there a reason why an _approximate_ solution to the dense
subgraph problem could not allow one to conclude that a CDO was more likely to
have been stuffed with garbage?

clearly if the problem is truly like encryption as Appel says then an
approximate solution is worthless (an approximate encryption key would still
give you garbage)

~~~
slackenerny
_Is there a reason why an approximate solution to the dense subgraph problem
could not allow_

I haven't read the paper either ;] (just skimmed bibliography to get a sense,
as I usually do first) but Arora (one of the authors) is an expert on
probabilistic approximations, and they do cite 2001 paper by Feige which is
standard ref. on approximations to dense subgraph. Also, what they reduce
their model to is a "planted" hidden clique variant of dense subgraph, a
problem which is hard "on average" and not only in worst case (propety used in
crypto protocols also).

~~~
kurtosis
I see - thanks for the info. I didn't know the background of the author or
recognize the reference. I'm going to read this one over much more carefully.

------
jwb119
>a CDO (collateralized debt obligation) is a security formed by packaging
together hundreds of home mortgages

there's actually another layer of abstraction involved. a mortgage backed
security, or collateralized mortgage obligation (CMO), is formed by packaging
together a large group of home mortgages. a CDO is made by packaging together
hundreds of MBS obligations or CMOs.

~~~
yangyang
CDOs are not necessarily just composed of mortgage derivatives. They can be
put together from bonds, CDSs (synthetic CDOs), syndicated loans (CLOs), other
CDOs (CDOs squared), a mixture of these and other debt instruments.

~~~
therealazeem
Yep. And you can count the leverage at every single level

------
leelin
Even if we had unlimited computation, there are human factors that are tough
to determine beforehand.

For example, some originators encouraged their borrowers to lie more, and now
post-meltdown some servicers are less willing to agree to loan modifications /
short-sales.

At first traders didn't place much emphasis on the originator, servicer, or
bank, because they focused on the loan stats (FICO score, loan type, interest
rate, etc).

Post-meltdown, the smart players see obvious systematic patterns between
originators and servicers, even given the same paper stats. But again, to see
it before it happened, it's less a computer problem and more an unscalable
human due diligence problem.

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chasingsparks
The link to the paper seems to be down. A clone can be found at
[http://www.princeton.edu/bcf/newsevents/seminar/SanjeevArora...](http://www.princeton.edu/bcf/newsevents/seminar/SanjeevArorapaper.pdf)

