Purpose (Thesis)

The thesis attempts to provide a speculative analytical framework for trading against financial institutions by the falsification of mathematical modeling currently applied in derivative pricing. Current mathematical models used in derivative pricing make certain assumptions about reality, which are crucial for the models to work. However, a certain drawback of these models is that they only take into account quantifiable risks and tend to disregard risks that cannot be quantified. We attempt to incorporate previous work of reflexivity and fallibility and apply it to the use of mathematical modeling. Reflexivity is a non-quantifiable measure that shows the pathways through which the participating agents biases/actions tend to affect the situations in which they participate, giving rise to a feedback loop between the participants views and reality. It is our opinion that there is a divergence between what we call the cognitive function, which attempts to understand reality and the participating function/bias which attempts to affect/change reality, in this case, the use of probabilistic measures to determine risk . We attempt to provide the reader with both technical and behavioral aspects that falsify the underlying bias of the accuracy of applying Newtonian physics to financial modelling. Financial institutions have lost more money than they have made since the history of banking in the 2008 crisis. Although this crisis was caused by a confluence of factors, one can argue that they were indeed amplified by the use of mathematical models in trading complex derivatives mostly within Securitization products and credit derivatives. The major financial institutions employ individuals having sophisticated mathematical and statistical backgrounds, yet mathematical sophistication enable the user to hide risks instead of exposing them. As long as risks measures are based on quantifiable measures, the intelligent speculative operator can derive an edge by understanding the flaws and pricing techniques of derivatives. Importantly we do not attempt to discredit the use of statistical methods or the application of mathematical modelling to financial markets, as profitability in periods of low volatility show consistency thus validating their use. Paradoxically we are aware that modelling can be profitably applied when dealing with random fluctuationsas in the case of short-term, high frequency trading however we argue that they are entirely ineffective with regards to reflexive processes in the market. Specifically we distinguish between two phenomenons, closed systems and open systems and that financial markets belong to the realm of open systems. Thus it is our opinion that currently there are no models that take completely into account all the factors that influence the market in order to effectively price an asset. Therein lies the opportunity for the intelligent speculator.

We specifically within this thesis attempt to identify how the credit cycle, mathematical models and behavioral aspects (misconceptions) of agents in the financial markets can interact and provide a favorable payoff (strategy) from the perspective of risk-to-reward for the intelligent speculator. This involves the use of OTC instruments, to be more specific, the use of Credit Default Swaps (CDS).and various Instruments priced on gaussian principles.

Example of Reflexivity the so-called fundamentals that supposedly determine stock prices are not independently given. Instead, they are contingent on the behavior of financial markets. There are, indeed, myriad ways in which stock prices affect the fortunes of companies: they determine the cost of equity capital; they decide whether a company will be taken over or acquire other companies; stock prices influence a companys capacity to borrow and its ability to attract and reward management through stock options; stock prices serve as an advertising and marketing tool. In other words, when financial markets believe a company is doing well, its fundamentals improve; when markets change their mind, the actual fortunes of the company change with them. Moreover, changes in financial markets also have far reaching macroeconomic consequences. (Soros)

An example of divergence of underlying reality and pricing risk. 4 Step structure

1)

Attempt to identify a self-validating flawed perception that reinforces market continuation. 2) Attempt to find companies/Institutions hiding risk within their accounting eg: (off balance sheet) 3) Understand the flawed mathematics or statistics pricing the company/Industry 4) Find Extremely attractive Risk to Reward Ratios OTC

Previous Research/ References Bachelier, L. J. B. A., Theorie de la Speculation (Paris: Gauthier-Villars, 1900). Das, S., Derivative Products and Pricing. John Wiley and Sons, Singapore, 2006.

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