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The formula that killed Wall Street

Discussion in 'Sports and News' started by 2muchcoffeeman, Feb 23, 2009.

  1. 2muchcoffeeman

    2muchcoffeeman Active Member

    Great read from the current issue of Wired. In short, it's this:

    <blockquote>In 2000, while working at JPMorgan Chase, Li published a paper in The Journal of Fixed Income titled "On Default Correlation: A Copula Function Approach." (In statistics, a copula is used to couple the behavior of two or more variables.) Using some relatively simple math—by Wall Street standards, anyway—Li came up with an ingenious way to model default correlation without even looking at historical default data. Instead, he used market data about the prices of instruments known as credit default swaps. ...

    It was a brilliant simplification of an intractable problem. And Li didn't just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number—one clean, simple, all-sufficient figure that sums up everything. ...

    Using Li's copula approach meant that ratings agencies like Moody's—or anybody wanting to model the risk of a tranche—no longer needed to puzzle over the underlying securities. All they needed was that correlation number, and out would come a rating telling them how safe or risky the tranche was. ...

    Bankers should have noted that very small changes in their underlying assumptions could result in very large changes in the correlation number. They also should have noticed that the results they were seeing were much less volatile than they should have been—which implied that the risk was being moved elsewhere. Where had the risk gone?

    They didn't know, or didn't ask. ...

    "Li can't be blamed," says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

    Nassim Nicholas Taleb, hedge fund manager and author of The Black Swan, is particularly harsh when it comes to the copula. "People got very excited about the Gaussian copula because of its mathematical elegance, but the thing never worked," he says. "Co-association between securities is not measurable using correlation," because past history can never prepare you for that one day when everything goes south. "Anything that relies on correlation is charlatanism."</blockquote>Read the whole thing here: http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
    Last edited by a moderator: Dec 15, 2014
  2. dixiehack

    dixiehack Well-Known Member


    Wait, what?
    Last edited by a moderator: Dec 15, 2014
  3. three_bags_full

    three_bags_full Well-Known Member

    I'll go a little farther back in time, and say the Black-Scholes models did as much as anything.
  4. Armchair_QB

    Armchair_QB Well-Known Member

    I blame greed.

    And soccer.
  5. SockPuppet

    SockPuppet Active Member

    I can't balance a check book so I have no idea what any of this means.
  6. zagoshe

    zagoshe Well-Known Member

    I blame Michael Brantley, Jim Young and Seth Davis at J.P. Marlin........
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