{"id":101,"date":"2008-02-20T21:10:56","date_gmt":"2008-02-20T20:10:56","guid":{"rendered":"http:\/\/www.pauljorion.com\/blog_en\/?p=101"},"modified":"2008-02-20T21:11:39","modified_gmt":"2008-02-20T20:11:39","slug":"pricing-models-why-the-good-one-are-useless-and-the-true-ones-priceless","status":"publish","type":"post","link":"https:\/\/www.pauljorion.com\/blog_en\/2008\/02\/20\/pricing-models-why-the-good-one-are-useless-and-the-true-ones-priceless\/","title":{"rendered":"Pricing models: why the good ones are useless and the true ones, priceless"},"content":{"rendered":"

I\u2019ve mentioned already in Agents using financial models and the \u201chuman cognitive cocktail\u201d<\/a> a number of pitfalls linked to the task of modeling the subprime<\/em> crisis in a Human Complex Systems perspective, especially those related to agents\u2019 partial understanding of the models they\u2019re using or in errors they\u2019re making when using them. I\u2019ve also hinted at some models making unwarranted claims about their ability at forecasting. I should also mention \u2013 as I was recently reminded \u2013 inflated assumptions about the virtues of diversification or, I should rather say, at the capacity of the markets to remain optimally diversified.<\/p>\n

I also said in the abstract of the presentation to be made on March 8th: The subprime crisis: a human complex system phenomenon<\/a> that the working of the financial instruments involved in the crisis [Asset-Backed Securities <\/em>(complex); Collateralized Debt Obligations <\/em>(complex); Asset-Backed Commercial Paper <\/em>(simple) and Credit-Default Swaps <\/em>(simple)] is relatively straightforward. There is however here a snafu which has to do with pricing: we have pricing models and pretty sophisticated ones at that but these are paradoxically known to be unlikely to provide any accurate picture of price.<\/p>\n

Our models of price formation are so far from predicting price accurately that an accounting directive implemented in 2007, FASB (Financial Accounting Standard Board<\/em>) 157 distinguishes between \u201cmarked-to-model,\u201d being assigned a Level 3 for reliability and \u201cmarked-to-market,\u201d the price that the market actually generated, assigned Level 1. Level 1 reliability is top while Level 3 is bottom.<\/p>\n

I plan coming back below to why \u201cmarked-to-model\u201d is so inefficient at predicting actual prices but let me first emphasize the conundrum we\u2019re in: that we not only possess pricing models but that these are regarded as \u201cindustry standard\u201d while at the same time there\u2019s no way we can use them in a Human Complex Systems\u2019 approach as they are known to be too ineffective at doing what they\u2019re aiming at doing, i.e. at giving an accurate figure for a price.<\/p>\n

This means that before we can even start with our Human Complex Systems approach we first need to provide a new model for pricing: one that really generates prices like real ones. Fortunately I\u2019ve already proposed one in an earlier blog: in Trouble\u2019s a Bubble, introducing the stock synthetic<\/a>. I copy the relevant passage below: <\/p>\n

\u201cThe dynamics of the market price is [\u2026] best described as a discrete dynamical system where the most recent settlement price is a function of past prices.
\nIt can be represented as
\nMaP t = F(MaP t-1, MaP t-2, \u2026);
\nwith MaP t standing for Market Price at time t.
\nA market price is clearly dynamic as its value changes with time; it is also discrete as each transaction generates a settlement price that applies to [a] specific volume [\u2026] exchanged between seller and buyer, and it is a function of past states as all agents base at any point in time their decisions to buy or sell on an analysis of past prices \u2013 be it crude or sophisticated.
\nThe speculative value (SpV) [\u2026] is simply [\u201cmarked-to-market\u201d price] minus [\u201cmarked-to-model\u201d price].
\nSpV t = MaP t \u2013 NaP t.
\nA bubble arises when SpV keeps growing.\u201d<\/p><\/blockquote>\n

Now a few words on \u201cmarked-to-model\u201d prices: these are typically based on \u201cfundamentals\u201d which is just another word for the components of the product that is being priced, and are \u201cadditive\u201d or in any case \u201caggregative\u201d – when elements are combined in a more sophisticated way than just being added to each other. Adam Smith called the \u201cmarked-to-model\u201d price the \u201cnatural price\u201d; in his terms: <\/p>\n

\u201cWhen the price of any commodity is neither more nor less than what is sufficient to pay the rent of the land, the wages of the labor, and the profits of the stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price\u201d (Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations<\/em>, Oxford: Oxford University Press, [1776] 1976: 72). <\/p><\/blockquote>\n

Benjamin Graham introduced in Security Analysis <\/em>(1934) the by now widely accepted concept that the non-speculative, i.e. \u201cnatural price\u201d of a stock can be calculated additively as the sum of all discounted future dividends, to which should be added the present value of the company\u2019s equity per share, in case the company folds some time in the future.<\/p>\n

The main difference therefore between \u201cmarked-to-model\u201d prices and \u201cmarked-to-market\u201d prices is that the former are \u201cextrinsic\u201d: calculating the price of a particular product from other prices – those of the product\u2019s components, while the latter are \u201cintrinsic\u201d: the price of the product is \u201cself-reflective\u201d being based on itself, more specifically on prior instances of itself. <\/p>\n

I first devised the discrete dynamical system model mentioned above when a futures <\/em>trader back in 1990 (Note sur l’utilisation de m\u00e9thodes emprunt\u00e9es \u00e0 la physique dans l’analyse technique des march\u00e9s<\/a>). In truth, anyone who has to forecast price variations in real time is forced to use some variety of this model. Models of this type typically determine if the most recent price is \u201cunder-valuating\u201d or \u201cover-valuating\u201d the market in the light of prior prices; such models are typically shallow as far as time-depth is concerned as \u201cnoise\u201d would otherwise rapidly accumulate \u2013 an acknowledgement of the fact that the \u201cextrinsic\u201d determination of price kicks in and forces realignment on \u201cfundamentals\u201d (*). Hence my title: “Pricing models: why the good ones are useless and the true ones, priceless.”<\/p>\n

(*) I have explained this in more detail in a paper published in French: Le prix et la \u00ab valeur \u00bb d\u2019une action boursi\u00e8re<\/a>. <\/p>\n","protected":false},"excerpt":{"rendered":"

I\u2019ve mentioned already in Agents using financial models and the \u201chuman cognitive cocktail\u201d<\/a> a number of pitfalls linked to the task of modeling the subprime<\/em> crisis in a Human Complex Systems perspective, especially those related to agents\u2019 partial understanding of the models they\u2019re using or in errors they\u2019re making when using them. I\u2019ve […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_crdt_document":"","footnotes":""},"categories":[6,12,11],"tags":[],"class_list":["post-101","post","type-post","status-publish","format-standard","hentry","category-finance","category-human-complex-systems","category-subprime"],"_links":{"self":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts\/101","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/comments?post=101"}],"version-history":[{"count":0,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/posts\/101\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/media?parent=101"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/categories?post=101"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.pauljorion.com\/blog_en\/wp-json\/wp\/v2\/tags?post=101"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}