Pseudorandom Financial Derivatives (working Paper)

Arora, Barak, Brunnermeier, and Ge [ABBG10] showed that taking computational complexity into account, a dishonest seller could increase the lemon costs of a family of financial derivatives dramatically. We show that if the seller is required to construct derivatives of a certain form, then this phenomenon disappears. In particular, we define and construct pseudorandom derivative families, for which lemon placement only slightly affects the values of the derivatives. Our constructions use randomness extractors and expander graphs. We study our derivatives in a more general setting than Arora et al. In particular, we analyze arbitrary tranches of the common collateralized debt obligations (CDOs) when the underlying assets can have significant dependencies.