Abstract
The authors of this paper claim that modeling financial markets based on probability theory is a severe systematic mistake that led to the global financial crisis. They argue that the crisis was not just the result of risk managers using outdated financial data, but that the employed efficiency model -- also referred to as the stochastic model -- is basically flawed. In an exemplary way, the analysis proves that this model is unable to account for interactions between market participants, neglects strategic interdependences, and hence leads to erroneous solutions. The central message is that the existing efficiency model should be replaced by an approach using agent-based scenario analysis.
Highlights
When considering the theory of financial markets, two different views emerge: the old view and the new view
In this paper we claim that modeling financial markets based on probability theory is a severe systematic mistake that led to the global financial crisis
We argue that the crisis was not just the result of risk managers using outdated financial data; we think that the employed efficiency model— referred to as stochastic model—is basically flawed
Summary
When considering the theory of financial markets, two different views emerge: the old view and the new view. As a result, according to the efficiency model, all information available is reflected in existing market prices This view is misleadingly simple and seriously incomplete. The banker’s fantasy is based on the assumption of irrelevance—the backbone of modern financial theory: Actions of market participants are irrelevant for the state of the market This means in our analogy that the banker’s action of sawing does not change the state of the branch. Bankers do dream that the branch, which symbolizes the price of a financial asset, does not crash; they observe that it sways somewhat To explain this movement, which is not at all related to the sawing, bankers invented a force majeure to decide whether the branch moves to the right or to the left depending on the random outcome of a tossed coin. The situation in which no player can gain by making a unilateral deviation from the original combination is called the Nash equilibrium. (Note 4)
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