If you can structure derivatives and other products in such a way that you can sell them to other people for more than they're worth, then you come out ahead. The cleverer you are at structuring them, and the better able you are to model their valuation, the more you can profit from other folks' stupidity. Basically, mugging people with your brains rather than your brawn.
As far as I understand it, beyond the basics of arbitrage, risk hedging and market making etc., investment banks are a zero-sum game - which after you add in the overheads and the profits, they destroy value.
So increased skill leads to markets that are less efficient because of complicated bundles of investments/loans? Why are complicated investments/loans even legal? What's the given justification for them?
My own train of thought lead in a similar direction as yours. What I'm really hoping for is the opinion of a hard core classical economist, because I feel like that's what I'm lacking. Are you familiar with such arguments? The free market determines salary, after all.
No, the markets are still efficient. It's just that intellectual capital is devoted to playing the market that could be devoted to other more productive things. If you want to borrow money, hedge risk or issue new stock you can do all that but there are fat profits to be had from being the smartest guy on the market or the one who figured out one particular arbitrage opportunity before anyone else.
Finance as waste: There's an arbitrage opportunity somewhere worth 100,000, and it will be picked up within a week of emerging. It is privately profitable to spend up to (100,000 - trading costs) to be the first to notice this, but the social benefits of it being discovered in 2 days rather than seven verge on zero.
Comments
If you can structure derivatives and other products in such a way that you can sell them to other people for more than they're worth, then you come out ahead. The cleverer you are at structuring them, and the better able you are to model their valuation, the more you can profit from other folks' stupidity. Basically, mugging people with your brains rather than your brawn.
As far as I understand it, beyond the basics of arbitrage, risk hedging and market making etc., investment banks are a zero-sum game - which after you add in the overheads and the profits, they destroy value.
So increased skill leads to markets that are less efficient because of complicated bundles of investments/loans? Why are complicated investments/loans even legal? What's the given justification for them?
My own train of thought lead in a similar direction as yours. What I'm really hoping for is the opinion of a hard core classical economist, because I feel like that's what I'm lacking. Are you familiar with such arguments? The free market determines salary, after all.
No, the markets are still efficient. It's just that intellectual capital is devoted to playing the market that could be devoted to other more productive things. If you want to borrow money, hedge risk or issue new stock you can do all that but there are fat profits to be had from being the smartest guy on the market or the one who figured out one particular arbitrage opportunity before anyone else.
Finance as waste: There's an arbitrage opportunity somewhere worth 100,000, and it will be picked up within a week of emerging. It is privately profitable to spend up to (100,000 - trading costs) to be the first to notice this, but the social benefits of it being discovered in 2 days rather than seven verge on zero.