Sunday, October 18, 2009

Algorithm Complexity Theory meets Financial Derivatives

Derivatives are computationally intractable - so is the claim made by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge in their new paper Computational Complexity and Information Asymmetry in Financial Products.

One of our main results suggests that it may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields.

The lemon problem clearly exists in real life (e.g., "no documentation mortgages"), and there will always be a discrepancy between the buyer's "model" of the assets and the true valuation. Since we exhibit the computational intractability of pricing even when the input model is known (N - n independent assets and n junk assets), one fears that such pricing problems will not go away even with better models. If anything, the pricing problem should only get harder for more complicated models. (Our few positive results in Section 5 raise the hope that it may be possible to circumvent at least the tampering problem with better design.) In any case, we feel that from now on computational complexity should be
explicitly accounted for in the design and trade of derivatives.

Link to original paper.

Will watch with interest whether
(1) the result bears up under scrutiny from complexity theorists.
(2) the result has any practical implications.

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