Tuesday, August 05, 2008

Intellectual Bubbles...

A more philosophical meandering today...

I have noticed a slew of recent articles proclaiming the end of exotic derivatives because of a "lack of transparency".

This is a nice way of saying alot of people bought what they did not understand and trusted the analysis of people they thought knew better.

"At best, probability describes perceived uncertainty" - Glyn Holton

Throughout history, the discovery of new mathematical ideas and techniques have led to people thinking that "this time, we have it!" This Epimenidian eureka effect has such strong underpinnings in humanity's relentless drive for progress and understanding that we often believe we have found "the answer".

Computation and simulation using Bayesian algorthims is another such discovery. It is an immensely powerful technique. One can simulate a huge variety of physical systems and receive probability distributions that correlate nicely to real-world observations.

Unfortunately, human market systems do not behave like physical systems. Atoms do not have the ability to choose. Human financial market participants seek to maximize profit - and engage in Keynsian beauty contests in order to do so. CEOs observe what their competitors do in making overplus profits and promptly copy them. And now, in this new era of cheap and ubiquitous computational power, all market participants have access to algorithmic models.

And so the participants created a bubble based on mathematical understanding, or the lack thereof. The gold rush for Wall Street for new ways to model boring old cash flows using math and computer power was on.

And so, investments have been flooded obscure mathematical models that purport to properly "price" a derivative within a given set of parameters (none of which, it seemed, included the non-zero probability of zero liquidity). Ostensibly, these models have been included to help clients understand what they had bought. A sort of "intellectual warranty" on these exotic products.

Too bad there was no fine print which paraphrased Mr. Theodore Sturgeon:

"Nothing is always absolutely so"

Bubbles can be intellectual as well as physical. And are no less dangerous.

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