From Dissonance to Resonance: Cognitive Interdependence in Quantitative Finance
London School of Economics & Political Science (LSE) - Department of Management
July 27, 2011
This study explores the elusive social dimension of quantitative finance. We conducted three years of observations in the derivatives trading room of a major investment bank. We found that traders use models to translate stock prices into estimates of what their rivals think. Traders use these estimates to look out for possible errors in their own models. We found that this practice, reflexive modeling, enhances returns by turning prices into a vehicle for distributed cognition. But it also induces a dangerous form of cognitive interdependence: when enough traders overlook a key issue, their positions give misplaced reassurance to those traders that think similarly, disrupting their reflexive processes. In cases lacking diversity, dissonance thus gives way to resonance. Our analysis demonstrates how practices born in caution can lead to overconfidence and collective failure. We contribute to economic sociology by developing a socio-technical account that grapples with the new forms of sociality introduced by financial models – dissembedded yet entangled; anonymous yet collective; impersonal yet, nevertheless, emphatically social.
Number of Pages in PDF File: 59
Keywords: Merger Arbitrage, Systemic Risk, Model
JEL Classification: C51, G10
Date posted: October 16, 2008 ; Last revised: July 29, 2011