A critical review of neoclassical modeling techniques in structured finance

Abstract

This paper presents a critical review of the neoclassical pricing models and assumptions used to valuate the products of structured finance using historical market data provided by credit default swaps. These models are founded on the idea that the efficient market hypothesis could be justification to use various credit derivatives to price-related assets. This market-based approach to pricing greatly simplified the complex nature of structured finance. However, it also created new risks that were not apparent to the market and subsequently grew unattended. These risks are identified and their connection to the real economy is explored in Keynesian, Davidsonian, and Minskian terms. It is the conclusion of this paper that a significant contributor to the credit crisis was market participants' reliance on the efficient market theory and lack of awareness of Keynes's key insights into uncertainty.

Keywords:

• structured finance
• efficient market theory
• credit crisis
• credit default swaps
• collateralized mortgage obligations
• asset correlation