Models, Reflexivity, and Systemic Risk: A Critique of Behavioral Finance

Abstract (via SSRN)

Daniel Beunza
London School of Economics & Political Science (LSE) – Department of Management

David Stark
Columbia University

This study considers the problem of systemic risk in financial markets dominated by models. Existing approaches debate the relative importance of financial models versus the biases introduced by social cues. In place of models versus social cues, our alternative account examines the interaction between models and social cues. Our ethnographic observations in the derivatives trading room of a major investment bank demonstrate that systemic risk arises from the precautionary efforts of traders. Traders check for errors in their own calculations by using models in reverse that represent the positions of their anonymous and impersonal rivals. We thus find traders modeling social cues. Such reflexive use of models leverages the dissonance among rival traders, but in the absence of requisite diversity such dissonance turns to resonance. If enough traders overlook a key issue, their mistake will reverberate to others. The resulting cognitive lock-in leads to arbitrage disasters. The trading room we observed suffered one major such disaster. Our analysis challenges behavioral accounts of systemic risk by locating its roots in the socio-technical mechanisms of reflexivity rather than individual biases

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10. May 2010 by Miguel Barbosa
Categories: Behavioral Economics, Curated Readings | Leave a comment

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