One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees. Full Story »
Posted by Kaizar Campwala
In a clear and unambiguous way, Felix Salmon has finally explained how the misuse of a single formula led to inflated bond ratings and our current financial meltdown. That he has done so in such a way that the average lay person can easily follow the story is even more remarkable. A must read.
During the past fifteen years we have twice harbored the unreasonable belief that certain immutable laws of economic gravity might have been repealed--first with the dot.com bust and now with the collapse of the credit bubble. The most salient point appears at the end of this article: "In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust."
The article gives about as clear of a layman's explanation of the modeling and the inappropriateness of that model as can be expected. The finger is appropriately directed at financial managers who did not understand the math and ignored their mathematical advisers.
Statistical distributions should never be assumed Gaussian, short term modeling should not be used for long term risks, robustness of models to violations of assumptions should be tested for any important model.
Investment banks would regularly phone Stanford’s Duffie and ask him to come in and talk to them about exactly what Li’s copula was. Every time, he would warn ... More »
The writer gives way too much credit to "the formula" while ignoring the history of investors vs speculators. The mentality of greed and sloth, failure to do due diligence, are given only passing fault while falling into the same trap of oversimplification. There are no simple answers to complex problem.
No one could have seen this coming, that is unless they were completely unaware of the financial markets for the last 100 years or even just back to the 1994 Orange County collapse based on nearly the same actions and data manipulation. Investors look at the data and don't take shortcuts since they are in for the long haul. Speculators want to know what can I make in the next 10 minutes. The same basic rules apply to formulas as to investment, if it seems too good to be true, it ... More »
From the report on the Orange County debacle - Beware the unconstrained star performer, even when he or she has a long track record. Where theres excess reward, ... More »
A terrific, deep well thought out piece on one of the causes of the market collapse, Loads of good research and depth, the writer went all the way with good references and the very obvious dangers of fool proof formulas..
Couple this formula with decades of poor government oversight, poor lending practices and irresponsible borrowers you have a disaster...
Retrieving Comments
