Wednesday, February 25, 2009

Financial Meltdown via Copula Functions

Very interesting story in the latest issue of Wired. The story claims that one of the main causes of the financial meltdown can be traced to a mathematical formula created by David Li. The formula (a Gaussian copula function) was designed to measure the correlation among returns of all of the various assets that made up collateralized debt obligations. The big problem with coming up with such a formula was the lack of information regarding the relationships among the underlying assets. Li's solution was to use past credit default swap prices as an indicator of correlation returns.

Great idea, but the problem was that the only CDS pricing information came from a time when home values were on a continuing upward trend. The inputs into the model (and therefore the output) weren't valid during time of decreasing home values. And, apparently, just about everybody was using the formula to price CDOs. Oops!

The Wired article has also caught the attention of our friends over at O&M.

Remember the words of Warren Buffett: "Beware of geeks . . . bearing formulas"

1 comment:

  1. It’s definitely interesting to read this stuff and working in Forex, I have learned to be keeping my eyes open for everything. I trade with OctaFX broker and they have brilliant daily market news and analysis service, it is pretty easy and simple to follow yet highly effective with giving me above 80% results and that too for long period of 6 months and still going extremely strong, so just loving it and their service is free of cost for all.