Looking Out, Locking In: Financial Models and the Social Dynamics of Arbitrage Disasters

Abstract:     
This study analyzes the opportunities and dangers created by financial models. Through ethnographic observations in the derivatives trading room of a major investment bank, we found that traders use models in reverse to look out for possible errors in their financial estimates. We refer to this practice as reflexive modeling. The strength of reflexive modeling resides in leveraging the cognitive independence among dispersed, anonymous actors. But as our analysis demonstrates, it can also give rise to cognitive interdependence. When enough traders overlook a key issue, their positions send the wrong message to the rest of the market. The resulting lock-in leads to arbitrage disasters. Our analysis challenges behavioral finance by locating the root of systemic risk in the calculative tools used by the actors, rather than in their individual biases and limitations.

Keywords: Merger Arbitrage, Systemic Risk, Model

JEL Classifications: C51, G10

Working Paper Series