Certifiably Pseudorandom Financial Derivatives

TL;DR

This paper introduces pseudorandom financial derivatives that resist strategic lemon placement by dishonest sellers, using expander graphs to ensure derivatives' values are minimally affected, even with complex dependencies.

Contribution

It defines and constructs pseudorandom derivatives under specific structural constraints, extending analysis to complex CDO tranches with dependent assets.

Findings

Pseudorandom derivatives are resilient to strategic lemon placement.

Expander graphs enable construction of derivatives with minimal value impact.

Analysis extends to complex CDO tranches with asset dependencies.

Abstract

Arora, Barak, Brunnermeier, and Ge showed that taking computational complexity into account, a dishonest seller could strategically place lemons in financial derivatives to make them substantially less valuable to buyers. We show that if the seller is required to construct derivatives of a certain form, then this phenomenon disappears. In particular, we define and construct pseudorandom derivative families, for which lemon placement only slightly affects the values of the derivatives. Our constructions use expander graphs. We study our derivatives in a more general setting than Arora et al. In particular, we analyze arbitrary tranches of the common collateralized debt obligations (CDOs) when the underlying assets can have significant dependencies.