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Pseudorandom Financial Derivatives

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Executive Summary

Arora, Barak, Brunnermeier, and Ge [ABBG] showed that taking computational complexity into account, a dishonest seller could dramatically increase the lemon costs of a family of financial derivatives. The authors show that if the seller is required to construct derivatives of a certain form, then this phenomenon disappears. In particular, they define and construct pseudorandom derivative families, for which lemon placement only slightly affects the values of the derivatives. Their constructions use expander graphs. They study their derivatives in a more general setting than Arora et al. In particular, they analyze entire Collateralized Debt Obligations (CDOs) when the underlying assets can have significant dependencies.

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