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

Looking Out, Locking In: Financial Models and the Social Dynamics of Arbitrage Disasters Daniel Beunza Department of Management London School of Economics [email protected] and David Stark Department of Sociology Columbia University [email protected] We are thankful to Michael Jensen, Katherine Kellogg, Jerry Kim, Bruce Kogut, Ko Kuwabara, David Ross, Susan Scott, Tano Santos, Stoyan Sgourev, Josh Whitford, Joanne Yates, Francesco Zirpoli and Ezra Zuckerman for comments on previous versions of the paper. 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. 1 Looking out, locking in: Financial Models and the Social Dynamics of Arbitrage Disasters On June 12th, 2001 the European Commission stated its firm opposition to the planned merger between two Fortune 500 companies. The Commission’s ruling put an end to the proposed combination between General Electric and Honeywell International, initially announced in October 2000. As news of the cancellation arrived on Wall Street, Honeywell’s stock price fell by more than ten percent. The drop caused losses of more than $2.8 billion to the professional arbitrageurs, hedge funds and investment banks that expected the merger to succeed. Beyond their size, the losses are significant because they penalized arbitrageurs, the pioneering users of financial models. For three decades now, quantitative finance has brought to Wall Street complex tools once confined to the realm of science (MacKenzie 2006). The failed merger between GE and Honeywell is thus fertile ground to understand the possibilities and pitfalls posed by financial modeling. What role, if any, do models play in financial disasters? We address this question with an ethnographic study of financial modeling. Our study focuses on the daily operations of a major international investment bank, pseudonymous “International Securities,” located on Wall Street. Its proprietary trading unit lost $6 million dollars in the GE-Honeywell deal. In examining this outcome, our analytic point of departure is the dilemma posed by models: they offer their users the possibility of extraordinary returns, but also create the risk of catastrophic losses. Our study investigates the ways in which traders grapple with their own fallibility, and how their efforts are mediated by models. Arbitrageurs, we found, not only use models to take positions but also to check their estimates 2 against those of their rivals. This form of reflexive modeling, however, can be dangerous because it creates cognitive interdependence among financial actors. A trader’s position becomes the cautionary sign used by his or her rivals. When a sufficiently large number of arbitrageurs overlook a critical factor driving merger failure, the use of models can provide misplaced confidence, leading to widespread and oversized losses. The occurrence of such losses has been well documented in the finance literature, and is referred to as “arbitrage disasters” (Officer 2007). Our analysis contributes to economic sociology by challenging the dominant accounts of systemic risk, rooted in behavioral finance. Behavioral accounts have attributed financial crises to individual biases: imitation, overconfidence, or lack of reflexiveness on the part of market actors. Our analysis questions this view by arguing that arbitrage disasters are not the outcome of these biases, but instead an unintended consequence of the material tools deployed by the actors – financial models-- to reduce risk and increase returns. In this sense, our study points to the double-edged nature of models. Along with greater precision and fewer losing trades, financial models also introduce the danger of oversize and widespread losses, that is, disasters. In the following pages we examine the ways in which models lead to crises. Our context is modern arbitrage. The first element of our study is to use our ethnographic observations to reconstruct how the arbitrageurs at International Securities dealt with a particular merger. That is, from numerous hours of observations across many trades, we offer a detailed analysis of a particular arbitrage opportunity. Our presence in the trading room meant that we could 3 analyze a given merger from the moment the merger desk learned about its announcement. We analyze how the traders “set up the trade,” starting with the PowerPoint presentations and videos from the merger announcement, leading to the use of Excel spread sheets and proprietary databases. With these modeling tools the traders build a picture of the merger, anticipating the future by drawing analogies to the past. Second, our ethnographic observations also demonstrate a counterintuitive aspect of financial modeling. Taking a position is only the first step in the trading process. Our research explores the next step, in which traders cast a sceptical eye on their own estimates. To do so they exploit the fact that other traders have also taken positions on the trade. Our arbitrageurs turn to a peculiar form of modeling, known as “backing out,” that yields the rivals’ estimate of merger probability. Knowledge of this implied probability can trigger search processes along new dimensions in previously unexamined territories. We refer to such a mechanism as reflexive modeling. Gaps, disparities, differences, and mismatches can produce positive friction that stimulates re-search. The lack of them gives traders greater confidence that their views are correct. The final step of our analysis examines how this reflexive process can contribute to arbitrage disasters. If a sufficiently large number of arbitrageurs simultaneously fail to see a merger obstacle ahead, the use of implied probability will provide traders with misplaced reassurance, leading them to expand their positions and suffer widespread, potentially catastrophic losses if the merger is cancelled. The reflexive use of models, in other words, creates systemic risk. 4 UNDERSTANDING INTERDEPENDENCE IN MODERN FINANCE Our study speaks to a growing interest in the interplay between models, systemic risk, and financial crises. Existing studies, mostly in behavioral finance, emphasize either the social or the model‐related aspects of financial crises – but fail to present a comprehensive portrait that takes both into consideration. Perspectives from behavioral finance One major strand of the behavioral literature points to overconfidence and excessive risk taking. According to the “house money” effect (Thaler and Johnson 1990) individuals become more willing to take risks when their performance improves – even if the underlying probability distribution remains unchanged (see also Battalio et al. 1990; Keasey and Moon 1996). But this research does not take models into account. Its underlying assumption is that actors construct a sense of risk and opportunity by direct assessment of their past performance. Modern modeling techniques, however, provide the decision-maker with alternative tools to estimate the probability distribution that he or she confronts. Traditional accounts of excessive risk-taking, thus, need to be updated to reflect the quantitative nature of how investors size up uncertainty. By contrast, financial models dominate “black swan” accounts of financial crises. Building on the Knightian distinction between risk and uncertainty, several authors have argued that crises occur when the unquestioned use of financial models leads banks to underestimate uncertainty (Taleb 2007; Derman 2004; Bookstaber 2007). The models used by these investors, the argument goes, assume a future that is excessively similar to the past. Investors assume, for instance, that 5 stock returns follow a Normal distribution. However, financial markets are social settings and therefore subject to unpredictable extreme events, or black swans. Instead of a Normal distribution, stock returns are more accurately described by fat- tailed distributions. To the extent that investors do not incorporate these exceptions into their models, their trading will be subject to the risk of disaster. An important shortcoming of the black swan argument is that it presents financial actors as hopelessly irreflexive about the limitations of their models. According to the proponents of the black swan, traders either ignore what every finance academic already knows – namely, that extreme events happen – or lack the reflexive capacity to act on it. Confronted by this argument, we ask, why should we deny to financial actors the capacity for reflexivity that we prize and praise in our own profession? Beyond overconfidence and modeling errors, behavioral studies have stressed the collective nature of financial

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