One of my students asked me why we should worry about a Greek default or exit from the euro when the markets can already factor those risks into the price of any assets likely to be affected in the markets. This is the same question that Gillian Tett highlights in her column in the FT last Friday. Tett’s answer is that there are always institutional quirks in the markets that are hard to factor into different prices. That answer should send investors – and their lawyers – to look through the fine print of marketable assets to find arbitrage opportunities that have not yet been exploited.
They shouldn’t bother. They may well find something worth exploiting but that won’t make it easier to price in the risks around Greece. The reason market participants fail to price such risks efficiently has less to do with the completeness of their models than with the fact that many if not most of them are going to switch from one set of models to another in the event of a Greek default. It is this model switching – and not the discovery of new information – that will roil the markets. Moreover, no-one can predict just how big of an impact this model switching will have on prices. I suspect it will be large.
Erik Jones 