Compounding Life

A friend forwarded me a link to this paper. It is quite interesting although the math is out of my league to fully understand it.

http://www.cs.princeton.edu/~rongge/derivative.pdf

Computational Complexity and Information Asymmetry in Financial Products

(Working paper)

Sanjeev Arora∗ Boaz Barak∗ Markus Brunnermeier† Rong Ge∗

October 19, 2009
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 find 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.

See also the webpage http://www.cs.princeton.edu/~rongge/derivativeFAQ.html for
an informal discussion on the relevance of this paper to derivative pricing in practice.