Wednesday, 15 April 2009

Interesting argument

Falkenblog reports on a talk by Robert Merton:
everyone castigates the markets for creating really complex instruments like derivatives, such as credit default swaps and mortgage backed securities. But, compare these assets to the assets and liabilities within a company: goodwill, deferred tax expense, intangibles, patents. Who can value these from first principles? Further, the company has the ability to change its business mix at any time, creating new products. We happily trade equities of these companies, and these are residual claims on this pyramid of assets and liabilities. Thus, the complexity of a mortgage-backed security of any sort is actually quite modest in that context.

Quite a good point, innit?

6 comments:

Nick Drew said...

it is an excellent point

and falling back to one of the most basic principles of Risk Management - if you don't understand it, don't trade it - I don't know how any individual can confidently trade most publicly-listed equities without insider information

incidentally, it's why Exxon stock has done so well for so long: they are a crap company but with a single redeeming feature - they stick rigidly to a (relatively) simple business model that can be fairly well understood and assessed

assessing classic paper derivatives is just a technical skill: valuing & risk-assessing them falls down only when people make crass (= unfoundedly optimistic) input assumptions

which brings us back to governance ...

Tom P said...

"I don't know how any individual can confidently trade most publicly-listed equities without insider information"

or how analysts can so confidently put a price on them.

chris said...

It's a good point. Here's a paper to back it up - the pricing of CDOs really isn't that complicated at all:
http://www.anderson.ucla.edu/Documents/areas/fac/finance/longstaff_toxic_assets.pdf

Tom P said...

link doesn't seem to work Chris - can you repost?

chris said...

Sorry Tom. Try the first working paper linked to here:
http://www.anderson.ucla.edu/x1924.xml

Nick Drew said...

fair point, although some might optimistically say (a) that they of all people should have some decent info (if not actually insider)

or at least (b) they are in the role of Keyne's beauty-contest judge (or an expert valuer of antiques, for example) whose skill is assessing what other people are willing to pay

actually of course it's worse than either of these, they usually reflect only herd-instinct and who's given them lunch (actual and metaphorical)

and that's when they're not being told what to say by another part of the organisation ...