> CDOs and related financial derivatives have been at the center of the current crisis and subject of ongoing regulatory overhaul.
> Despite their demonstrable benefits in economic theory, derivatives suffer from the practical drawback
> that pricing them accurately is often difficult even for sophisticated trading banks using powerful computers.
> We propose a new explanation: the pricing problem is computationally intractable.
> We also quantify the economic implications of this computational intractability. According to economic theory,
> derivatives are beneficial because they mitigate the effects of asymmetric information (i.e., in settings where
> sellers know more about the product than the buyers, a scenario studied in the classic paper of Akerloff).
> We show that this may no longer hold when we take computational complexity into account. Using an Akerloff-like notion of "lemon cost" we can show that derivatives can in fact amplify the effects
> of asymmetric information.
> Our notion of lemon cost can also differentiate between different types of derivatives, say CDOs and CDO2, supporting the traditional belief that the latter are more "complex."
> (Joint work with Boaz Barak, Markus Brunnermeier, and Rong Ge.
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