Sunday, September 8, 2013

Undoing the pretzel logic of finance

My latest column in Bloomberg came out a few days ago. The article looks at some recent work of young MIT economist Alp Simsek that considers how new derivative instruments influence market stability. He comes to a conclusion that most ordinary people would find utterly unsurprising:
Financial markets in recent years have seen a proliferation of new …financial assets such as different types of futures, swaps, options, and more exotic derivatives. According to the traditional view of …nancial innovation, these assets facilitate the diversi…cation and the sharing of risks. However, this view does not take into account that market participants might naturally disagree about how to value …financial assets. The thesis of this paper is that belief disagreements change the implications of …nancial innovation for portfolio risks. In particular, market participants’' disagreements naturally lead to speculation, which represents a powerful economic force by which fi…nancial innovation increases portfolio risks.
There you go. Because not all people have the same views on the future, derivatives can be used to speculate and gamble. This increases risks in the market. More derivatives and more complete markets is not always a good thing, as standard financial theory would have it.

To be clear, I'm not poking fun at Simsek's work. Not at all. I think this work should be spread far and wide. That this idea comes as news to the academic finance community shows how deeply confused they have become by the received wisdom of market completeness as an ideal. They (at least many) do believe that UP = DOWN, and so news to the contrary sounds radical. In the article I've mentioned several other earlier studies (I've written about them here before, just search on "derivatives") that point to the same conclusion: more derivatives in general leads to more market instability (again, as most people already believe).

It's nice to see some influential young economists picking up and exploring this idea.

10 comments:

  1. Market instability is a good thing in the longer term because is tranfers wealth from speculators to value investors. MIT is wrong - gain...

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  2. For whatever reason you would like to give the birth of derivatives - and for whatever good that they may have initially brought to the financial markets - it is very clear that they have morphed into a parasitic organism feeding of its host.

    The problem is the host, the general public, is being told the parasite, wall street, is an vital organ that needs to be protected and nourished. In reality it needs to be cut off and discarded.

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