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Computational Complexity and Information Asymmetry in Financial Products

The US Department of Veterans Affairs administers a number of educational benefit programs for veterans. These include, but are not limited to, the Montgomery GI Bill and the Post-9/11 GI Bill (9/11 GI Bill). The 9/11 GI Bill assists eligible individuals with tuition and fees, a monthly housing allowance, annual books and supplies stipend, and a one-time rural benefit payment for eligible individuals. In addition to the 9/11 GI Bill providing an education benefit for eligible veterans, the education benefit may also be transferred to dependents under certain conditions. The 9/11 GI Bill also has a provision that established the Yellow Ribbon Program. This program assists with funding tuition and. | Computational Complexity and Information Asymmetry in Financial Products Working paper Sanjeev Arora Boaz Barak Markus Brunnermeiery Rong Ge Oct. 19 2009 Abstract Traditional economics argues that financial derivatives like CDOs and CDSs ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive part of the cash flow stream of an asset e.g. a mortgage and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources. See also the webpage http www.cs.princeton.edu rongge derivativeFAQ.html for an informal discussion on the relevance of this paper to derivative pricing in practice. Department of Computer Science and Center for Computational Intractability Princeton University arora boaz ronggeg@cs.princeton.edu Department of Economics and Bendheim Center for Finance Princeton University markus@princeton.edu 1 1 Introduction A financial derivative is a contract entered between two parties in which they agree to exchange payments based on the performance or events relating to one or more underlying assets. The securitization of cash flows using financial derivatives transformed the financial industry over the last three decades. In recent years derivatives have grown tremendously both in market volume and sophistication. The total volume of trades dwarfs the world s GDP. This growth has attracted criticism Warren Buffet famously called derivatives financial weapons of mass destruction and many believe .