Complexity In Financial Markets
There’s been a lot of talk on complexity & financial markets -this paper does the topic justice.
Abstract (Via Markus K. Brunnermeier & Martin Oehmke)
Should we regulate complex securities, subject them to an FDA-style approval process, or limit who can invest in them? To answer these questions, one first needs to establish why complexity matters, and what defines a complex security. Complexity is an important concept in financial markets with boundedly rational agents, but that finding a workable definition of complexity is difficult. For example, while CDOs are viewed by most as highly complex, equity shares of financial institutions, whose payoff structures are even more complicated, are often seen as less complex. We point out three different ways in which boundedly rational investors can deal with complexity: (i) by dividing up difficult problems into smaller sub-problems or by using separation results, (ii) by using models – simplified pictures of reality, (iii) through standardization and commoditization of securities. Importantly, simply increasing the quantity of information disclosed to investors does not resolve complexity, since in the presence of bounded rationality it leads to information overload.
Excerpt (Via Markus K Brunnermeier & Oehmke)
In this article we comment on the role of complexity and complexsecurities in financial markets. We focus on three main points that are central to a well-informed debate about complexity. First, we point out that, at a theoretical level, complexity only becomes important in financial markets when agents are boundedly rational. This means that in order to tackle issues relating to financial market complexity, economists have to step outside of the rational paradigm, which most of classical asset pricing theory is based on. Importantly, we point out that in the presence of bounded rationality more information per se does not help investors make well-informed investment and risk management decisions. This is because simply increasing the quantity of information disclosed can lead to information overload – a boundedly rational investor who receives an entire truckload of documents will be overwhelmed by the amount of information he needs to distill. Consequently, the way in which information is disclosed becomes crucial. This has important implications for designing disclosure requirements for consumer protection.
Most Important Excerpt (Via Markus Brunnermeir & Oehmke)
Consequently, in the bounded rationality setting more information may not necessarily lead to more informed investment decisions or risk management by the investor. Rather than simply the quantity of information, the way in which information is presented and how an investor reduces complex interdependencies becomes crucial. In addition, information release may introduce information asymmetries if some market participants are better at processing information than others, potentially leading to market breakdown due to a lemon’s problem. Or, alternatively, when complexity is so high that no investor finds it in his interest to collect information, information is still symmetric among investors, but a large amount of hidden information may build up in the background, leading to large and sudden price adjustments when this pent-up information is finally released.