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Sunday, February 17, 2013

Risk Arbitrage

When an asset is valued differently in two different markets, shrewd investors can take advantage of such situations by buying in one market and selling in another and pocketing the spread. Someone will become very wealthy if they can figure out how to exploit similar phenomenon in the realm of other risks.

Earlier this week there were two stories juxtaposed in the WSJ which highlighted how irrational we are when we express fears of specific risks. The stories were on what at first appears to be very disparate topics. The first was on the risks of headers in soccer players. In this study, investigators at the Imperial College in London measured the impact of a regular soccer ball inflated at normal pressures travelling at speeds readily attainable in non-professional play contexts. What they determined was that the impact of an adult soccer ball to the head was roughly equivalent to what would be experienced when being punched in the head. Based upon what is now known about head injuries this sounds like a real issue and a real threat, particularly to children and young adults who play soccer in droves.

The second story was on a meta analysis of studies of bis-phenol A (BPA), which is used an additive in a variety of plastics, particularly items holding food or water. The study was funded by the EPA and results presented at the American Association for the Advancement of Science (AAAS). It included data from 30,000 people in 19 countries, including women and infants. The conclusion of the study are the BPA exposure occurs at levels thousands of times lower than you see any effects in animals.

The stories presented two distinct perspectives on the respective risks. The head injury study is so obvious that it borders proving common sense. Do I expect the the results of this study to have any particular immediate effect on our behavior? No, not likely. I raised my children with a healthy dose of competitive soccer, as well as a host of competitive sports. I was constantly amazed at the acceptable levels of trauma and risks in these realms. Injuries were the norm, not the exception, and even routine occurrences which resulted in the requirement for emergency visits, surgery, general anesthesia, and prolonged convalescence (associated with substantial financial impact) failed to lessen enthusiasm for the competitive athletic culture.

If one does a web search using the terms bisphenol A health risks you get 167,000 hits. If one does a similar search using the search terms soccer headers brain damage you get on 25,000 hits. It is part of a greater trend. Raise the possibility that there some sort of "chemical" within the same zip code as our children and our risk tolerance changes dramatically. 21st century Luddites rail against the risks of dangerous "chemicals" including pesticides, sunscreens, non-stick cookware,personal care products, household cleaners, and virtually any other synthetic enhancement. These chemicals represent the witches of our times and they are viewed as much more dangerous than plain old blunt trauma, real evidence and data not withstanding. Better to just burn the witches as part of the precautionary principle. Better to be safe than sorry.

We are much more concerned about the essentially non-existent threat of BPA than the real risk of brain damage. This is just stupid. Within the financial markets, you can get rich when wagering against dumb investors and it tends to get rid of the dumb investors or at least the particular stupid investment decisions. It is too bad there is no similar arbitrage available to bet against other ill informed and superstitious players.

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