The proliferation and increasing complexity of complex financial instruments is dangerous, writes FT columnist John Kay.
To understand both this multiplication and its dangers, he says, it is helpful to understand a bit of auction theory, a popular concept here on Alphaville.
Kay says investors in complex financial products often fall victim to the so-called “winner’s curse” – in which an object of uncertain value is more likely to be owned (i.e. won in an auction) by people who overestimate that value than by people who underestimate it.
“European mobile phone companies paid too much for their auctioned 3G licences because telecommunications companies are run, and their shares owned, by people excessively optimistic about the future of mobile telephony,” he says. “Businesses are always managed, and shares are always owned, by people who think these businesses have good prospects.”
So what does auction theory have to do with “exotic derivatives”, “collateralised debt obligations” and “credit risk insurance”? It’s all in the eye (or wallet) of the beholder.
“The fundamental value of a security — the return it will deliver to its holder — does not vary much between potential holders but assessments of that value can vary by a lot,” he says.
Since complexity increase uncertainty, more often than not, “trading puts assets in the hands of those who think these assets are more valuable than they are.”
Kay poses three questions to potential investors in complex financial products:
- Should you trust your own judgement when your analytic skills as buyer are so much more limited than those of the seller?
- Do you really want to buy products when it is impossible to specify the underlying risks?
- And — especially when you reach the bargain basement — ponder why you want to buy what someone else is so anxious to sell
Failure to consider these questions could lead to pain and disappointment when you finally “unwrap” your purchase.