New paper on complexity and financial derivatives

Sanjeev Arora, Boaz Barak, Markus Brunnermeier and Rong Ge just posted a paper on Computational Complexity and Information Asymmetry in Financial Products. (Link is to an informal “Frequently Asked Question” page, containing also the paper itself.)

The paper shows that in certain settings it can be computationally infeasible to verify that a financial derivative such as a collateralized default obligation (CDO) is properly constructed, in the sense that there is sufficient diversity of assets so that the derivative is not overly sensitive to some small  segment of the market.  Moreover, it may be possible to generate derivatives that are sensitive to such a small market segment, but are indistinguishable from properly diverse ones, implying an opportunity for the seller to make a profit  if he has private information that a particular segment is worth less than it appears (i.e., a “lemon”).

Several blogs also commented this paper including: Freedom to Tinker, Boing Boing, Daily Kos, In Theory,  Healthy Algorithms (including code to generate concrete computational challenges),  Lipton’s blog.