Monday, October 19, 2009

Study Proves That Derivatives Are Hard to Price

There is a new paper out titled. "Computational Complexity and Information Asymmetry in Financial Products." Here is the link to a link that will get you there. Here's the money quote from the paper.

Click for a larger image.

First, If you want to get an idea for what's involved, read any of the bond books written by Frank Fabozzi -- they explain the process really well. If you really want to see what's going on with these products, get the Mortgage Backed Securities Workbook which will show you how to use an Excel Spreadsheet to make your very own CMO.

Second, let's back the bus up and get some history. Securitization has been around for about 30 years. It originally involved the mortgage industry, but then expanded into anything that has a fairly predictable cash flow -- credit cards, airplane receivables (the trusts that airlines set-up to lease airplanes) -- you get the idea. In other words, this idea/concept has been around for long enough and used in a a wide enough series of financial situations that we know it can work without blowing up the world.

So what led to the latest blow-up? A large number of inter-related issues that when put together allowed a market -- which BTW had worked really well for some time -- to get completely out of hand. What were these problems? Here are a few: ultra-low interest rates, complete lack of regulatory oversight, a ratings industry that was whoring itself out to the highest bidder, using the wrong financial product sold to the wrong people to sell homes, a financial culture that does not have any "skin in the game etc... In other words, we got here through the culmination of many events combining into one giant cluster.

Back to the article at hand, it basically says we can't price these things. But that leads to a problem: there are many financial products that "can't be priced." Let's start with a simple share of stock. Yes, there is the price quoted by the market. But then there's the value investor who says the share is really worth X because of a set of unconsidered factors. And what about an illiquid bond? The price quoted there is going to jump around as well depending on perception. And what about a thinly-traded option where you can drive a truck through the bid/ask spread? What's the real value there? The answer is it depends. Should all of these products now be banned because we can't get a uniformly stated price?

It's also important to remember this is not the first time we've been through a derivatives problem. The same thing happened when the option market started to use the Black Schoales pricing model. When that happened, we were all going to hell. 40 years later it's standards practice.