"Computational Complexity and Information Asymmetry in Financial Products," a new paper by Princeton computer scientists and economists Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge suggests that complex financial derivatives are computationally intractable: that is, once you have mixed together a bunch of weird-ass securities and derivatives, you literally can't tell if the resulting security is being tampered with as it pays off (or doesn't). Freedom to Tinker's Andrew Appel likens it to cryptography: you can mix together a bunch of known quantities to get a new number that can't be turned back into the old numbers.
The paper shows the example of a high-volume seller who builds 1000 CDOs from 1000 assert-classes of home mortages. Suppose the seller knows that a few of those asset classes are "lemons" that won't pay off. The seller is supposed to randomly distribute the asset classes into the CDOs; this minimizes the risk for the buyer, because there's only a small chance that any one CDO has more than a few lemons. But the seller can "tamper" with the CDOs by putting most of the lemons in just a few of the CDOs. This has an enormous effect on the senior tranches of those tampered CDOs.
In principle, an alert buyer can detect tampering even if he doesn't know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem ("densest subgraph"). This problem is believed to be computationally intractable; thus, even the most alert buyer can't have enough computational power to do the analysis.
Arora et al. show it's even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his "senior tranche"), he can't prove that that tampering occurred: he can't prove that the distribution of lemons wasn't random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.
Intractability of Financial Derivatives
TIL: Sharks are attracted to the sound of death metal. Apparently, the “dense tones” of it mimics the “low frequencies of struggling fish.” (Damn.) In 2015, a Discovery Channel crew — hoping to attract a large great white named “Joan of Shark” — dropped a speaker underwater and played some. Independent: Desperate to feature the […]
The mystery of the glorious fireball emitted by microwaved grapes (featured in my novel Little Brother) has been resolved, thanks to a paper in the Proceedings of the National Academy of Sciences in which Trent University researchers Hamza Khattak and Aaron Slepkov explain how they destroyed a dozen microwaves before figuring out that the grapes […]
The rise in a belief that the Earth is flat is bizarre and somewhat frightening, a repudiation of one of the most basic elements of scientific consensus. Texas Tech University psych researcher Asheley R. Landrum attended a 2017 flat earth convention and interviewed 30 attendees to trace the origins of their belief in a flat […]
Looking to de-clutter your kitchen counter? Start with those multiple, tangled charging cables for your multiple, power-hungry devices. There’s a workhorse solution for all those power needs, and it’s just as just as well suited to travel as home use: The Scout Wireless 5000mAh Charger. Compact and sleek at nine ounces, it doesn’t look like […]
Use a single password for every website, and you’re compromising your security. Use a different one each time, and you’re bound to lose track of them. The solution? RoboForm Everywhere, a catch-all tool that will not only manage the passwords on every site you visit but generate better ones. As a simple password database, it’s […]
Just a reminder: Print isn’t dead. And now that printers are becoming as portable as cell phones, it might be around for quite some time. Enter the MEMOBIRD Mobile Thermal Printer, a mini-printer that is versatile, portable – and most importantly, never needs a refill on ink or toner. Measuring just a few inches around, […]