Well, at least according to the Oxford English Dictionary: misprice is not an English word. And yet, the term has been used ad nauseam throughout this economic crisis and, indeed, even within the pages of this blog. The reality is, we can either ‘not’ price something, at which point it becomes priceless, but to misprice is, by definition, a contradiction in terms.
But can we really state that all those CDO, CLO, and other derivative trades were truly ‘priceless’? Sounds a bit like a MasterCard ad here, and I’m not too sure that’s actually what occurred.
Nonetheless, the act of pricing involves two economic agents coming together in the form of a trade and agreeing then on a settlement amount, ie on a price. What we have noticed, though, is that when two economic agents meet and are misinformed they might make a mistake on their valuation. However, even here, it is incorrect to state that they then ‘mispriced’ their trade (I know that finance has its own dialect but still).
So what is happening then?Markets are designed so that multiple economic opinions can meet and come to an agreement. Underpinning this statement is the simple fact that not all trades will match the ‘real’ value sought out by either party. But it is specifically this plurality and potential for ongoing price discovery that defines and provides economic markets with their real potential. All prices in the market are, technically speaking, correct. These prices may move and be volatile, but they do not, for as much result in a ‘mispricing’.
There’s a nice little theory in economics that tries to encapsulate this phenomenon: “creative destruction“.
The Austrian School
This term, first coined economically by Joseph Schumpeter, highlights the ongoing value that price-discovery, and even abrupt market volatility, can have for the economic system. By extending this, we can illustrate that all pricing activity assists us in gaining greater granularity in the decision process and the more ‘liquid’ this pool becomes the less disruptive any decision or action becomes.