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“The Final Problem”

July 22, 2012

“The Final Problem” http://en.wikipedia.org/wiki/The_Final_Problem is a Sherlock Holmes story that contains interesting references to modern game theory. Holmes- the legendary detective- is on a mission to foil an equally intelligent adversary- Moriarty. Holmes is forced to choose beyond conventional decisions to account for the fact that Moriarty is likely to deduce his response based upon what he himself would do in such a situation. A good analysis/synopsis of the problem is presented by Blume in presentation on game theory: http://www.pitt.edu/~ablume/Game%20Theory%20Principles/game-slides-3.pdf

Both central banks and large investors are constantly engaged in these type of games. This often baffles less sophisticated investors who are looking for market responses that reflect the favorability of decisions made by central banks. Instead, the response is a complex reaction based upon expectations and the degree to which they are already priced. It is worthwhile to think of “The Final Problem” as a useful analog when considering what direction the market may take given a policy event or announcement.

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