Zero-Sum games with results being decided far into the future can trick participants into thinking they’ve just entered a win-win transaction where both of them come out ahead. This is similar to a conman “overpaying” for goods with counterfeit money - both the conman and the merchant go home happy. The merchant is in for a rude surprise only after he tries to use that money. The pain he experiences is in direct proportion to the happiness he felt earlier.
Derivatives transaction, stock market transaction with a fixed money-supply, and forex speculation are all zero-sum games. Derivatives are the most interesting because they let traders push the uncertainty out far into the future. Consider two traders who enter a derivatives transaction with an expiration date two years out. If the market is illiquid, they can both happily “mark to model” and book paper profits if they use different models. In fact, since they entered the transaction in the first place, they probably are using different models.
Even “mark to market” transactions are susceptible to model-error, just less so. The market as a whole is an average of many models, any sharp change in this average will expose participants to model error. Even if the merchant was paid in real dollars for the asset, he can still lose out if rampant inflation sets in and the asset’s value doesn’t change but the cash in his hands is steadily becoming worthless. The model that the market used for currencies changed and the change did him in.
As in the counterfeit money transaction, the person who is assuming a tightly-constrained game (ludic fallacy) will emerge as the loser. False premises are usually the root problem (these dollar bills are real, cash will be worth the same tomorrow, this cannot happen in this market, …).
In fact, the presence of win-win players in what is known to be a zero-sum game can be used as a diagnostic tool to prepare for massive reality-checks in the future. Hedge Funds and Investment Banks all tend to trade with each other. And they particularly enjoy derivatives transaction. If most hedge funds end up showing stellar returns for an extended period of time, it shouldn’t come as a big surprise that at least some of them have been borrowing from destiny.
Post a Comment