Information (In)Efficiency in Prediction Markets

We analyze the extent to which simple markets can be used to aggregate dispersed information into efficient forecasts of unknown future events. From the examination of case studies in a variety of financial settings we enumerate and suggest solutions to various pitfalls of these simple markets. Despite the potential problems, we show that market-generated forecasts are typically fairly accurate in a variety of prediction contexts, and that they outperform most moderately sophisticated benchmarks. We also show how conditional contracts can be used to discover the markets belief about correlations between events, and how with further assumptions these correlations can be used to make decisions

The virtues and vices of equilibrium and the future of financial economics

The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn't be a question of dogma, but should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics.Comment: 68 pages, one figur

Systemic Risk

Governments and international organizations worry increasingly about systemic risk, under which the world’s financial system can collapse like a row of dominoes. There is widespread confusion, though, about the causes and even the definition of systemic risk, and uncertainty about how to control it. This Article offers a conceptual framework for examining what risks are truly “systemic,” what causes those risks, and how, if at all, those risks should be regulated. Scholars historically have tended to think of systemic risk primarily in terms of financial institutions such as banks. However, with the growth of disintermediation, in which companies can access capital-market funding without going through banks or other intermediary institutions, greater focus should be devoted to financial markets and the relationship between markets and institutions. This perspective reveals that systemic risk results from a type of tragedy of the commons in which market participants lack sufficient incentive, absent regulation, to limit risk-taking in order to reduce the systemic danger to others. Law, therefore, has a role in reducing systemic risk

Complexity Science Models of Financing Health and Social Security Fiscal Gaps

Many think health and Social Security markets and social insurance programs are broken because they are increasingly unaffordable for too many Americans. Bending the cost curve down has become a standard reference term for the main objective of reform proposals to slow cost increases or even reduce them. This paper presents an alternative model with preliminary results of statistical analyses of complexity science simulation models with historical data that quickly bend the GDP curve up to increase affordability. This paper looks beyond popular reform models to self-organizing complexity science models based on chemistry, physics, and biology theories to suggest sustainable, long-term financial reform proposals. The foundation of these proposals is not based on orthodox market failure economic models but rather on thermodynamics in general and the time evolution of Shannon information entropy in particular:complexity science,financing fiscal gaps, health and Social Security, & macroeconomics

A Radical Shift in Managing Risks: Practical Applications of Complexity Theory

Complexity theory is designed to bring order out of a rough-and- tumble world, something close to every insurance professional's or actuary's heart. Whether applied in the laboratory or as part of a mathematical model, it can do wonderful things . But in the real world it's just what its name says-a theory. It may help us understand why things go one way or another, but it can't foretell those things with such certainty that an insurance company could, say, set its rates based on the knowledge that only one hurricane will strike Florida during the coming year...Complexity theory; risk; risk management; managing risk; climate change; global warming; chaotic systems; weather; hedging; hedge

The Virtues and Vices of Equilibrium and the Future of Financial Economics

The use of equilibrium models in economics springs from the desire for parsimonious models of economic phenomena that take human reasoning into account. This approach has been the cornerstone of modern economic theory. We explain why this is so, extolling the virtues of equilibrium theory; then we present a critique and describe why this approach is inherently limited, and why economics needs to move in new directions if it is to continue to make progress. We stress that this shouldn’t be a question of dogma, but should be resolved empirically. There are situations where equilibrium models provide useful predictions and there are situations where they can never provide useful predictions. There are also many situations where the jury is still out, i.e., where so far they fail to provide a good description of the world, but where proper extensions might change this. Our goal is to convince the skeptics that equilibrium models can be useful, but also to make traditional economists more aware of the limitations of equilibrium models. We sketch some alternative approaches and discuss why they should play an important role in future research in economics.Equilibrium, Rational expectations, Efficiency, Arbitrage, Bounded rationality, Power laws, Disequilibrium, Zero intelligence, Market ecology, Agent based modeling

How do Croatian Companies make Corporate Risk Management Decisions: Evidence from the Field

According to the Capital Asset Pricing Model and the Modigliani-Miller theorem, corporate risk management is irrelevant to the value of the firm. However, it is apparent that managers are constantly engaged in hedging activities that are directed at the reduction of corporate risks. As an explanation for this clash between theory and practice, imperfections in the capital market are used to argue for the relevance of corporate risk management function. This paper analyses corporate risk management practices and decision to hedge in large Croatian non-financial companies. It explores if decision to hedge corporate risks in the analysed companies is a function of several firm’s characteristics that have been proven as relevant in making risk management decisions.corporate risk management decision, hedging rationales, shareholder value maximisation, managers’ private utility maximisation, large Croatian non-financial companies