Felix Salmon has a terrific cover story in this month’s Wired on the all-too-seductive Gaussian Copula function, which made it easy to calculate risk on Wall Street. Take a big basket of financial instruments, each with their own risks, through them into the Copula function, and presto: you get the net risk. It was so beautiful and apparently bulletproof that investors began treating it like a black box. Then it all went wrong.
This story profiles David X. Li, the inventor of the formula (now living in China), and how its adoption led to the chronic mispricing of risk that toppled some of the largest banks.
It’s a hell of a story, for students of Wall Street and mathematics alike. Here’s the function, annotated (yes, we’re aware that it seems to be missing a parenthesis, but that’s in the original paper, too):
Chris,
Thanks for sharing. It brings the following to mind:
"Common knowledge is always correct."
(Until, it is not.)
I guess we've come to the painful realization that the financial world is no longer flat.
Hm.
Great lessons for kids in school, who are taught to accept everything in a text book as gospel.
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Posted by: Jimmy | February 26, 2009 at 07:03 AM
Well, i think that the Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy.
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Posted by: bruce | February 26, 2009 at 04:20 PM
Well, i think that the Wall Street turned to the quants—brainy financial engineers—to invent new ways to boost profits. Their methods for minting money worked brilliantly... until one of them devastated the global economy.
We are in search of product and service reviewers to work from home. You need basic computer and internet skills and the ability to follow directions. This is a contract job with the possibility of becoming part time. All that we ask that you have is a home computer and that you are a citizen of the USA. This is a very simple job to complete and you can do it from home.
----------------------------------------
bruce
http://stealthyshoppers.com/
Posted by: bruce | February 26, 2009 at 04:24 PM
Truly top rate writing and analysis. I particularly like that the article links to a WSJ article from 2005 quoting Li on the dangers of treating the Gaussian Copula as if it created gospel truth.
Posted by: Adam | February 26, 2009 at 05:42 PM
Its really a Quant's job to be able to explain the subtleties about how this equation works and how it doesn't, but the problem with pricing models is that they can be abused to boost someone's bottom line on paper. People can abuse this pricing model by using it when it should not be used.
Unfortunantely there is no quick fix to this, because for accounting purposes people need to create some numerical dollar value for their assets, and when you have ill-liquid assets (like houses, for example) there doesn't exist such a thing as a "market price" at every given time.
Posted by: robert | February 28, 2009 at 05:09 PM
i agree... in every problem.. there's a solution.. right?
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Posted by: Kampanye Damai Pemilu Indonesia 2009 | March 07, 2009 at 10:18 AM
Is this the right place to report that this edition of Wired print magazine is entirely unavailable (study of 15 newsagents and 5 book megastores on 9th March 2009) in Islington, North London?
A large percentage (anecdotal) of London's largest bankers live in this part - I realise it's available online but still....we'd all benefit from this lesson as we (I work with bankers and am not a wan..um....banker) buy our dying newspapers,'fags', and other confectionary.
To the Wired publishers - please extend distribution network in North London.
Posted by: James | March 09, 2009 at 05:22 AM
Fantastic. Thanks so much for bringing this to my attention. I'll take a look at the cover article this evening.
This is a great example of the bogus science and theory that supports so much of conventional finance.
The Markowitz mean-variance frameword (diversify with some precautionary savings and everything will be fine in the long-run) falls squarely in this camp.
Posted by: Tom Cochrane | April 16, 2009 at 07:49 PM
Truly top rate writing and analysis. I particularly like that the article links to a WSJ article from 2005 quoting Li on the dangers of treating the Gaussian Copula as if it created gospel truth.
Posted by: gaia gold | June 14, 2009 at 11:45 PM
i agree with you. in the world now all many problems :)
Posted by: aion kinah | June 14, 2009 at 11:47 PM
Take a big basket of financial instruments, each with their own risks, through them into the Copula function, and presto: you get the net risk. It was so beautiful and apparently bulletproof that investors began treating it like a black box. Then it all went wrong.
Posted by: maple story mesos | June 16, 2009 at 12:17 AM
This story profiles David X. Li, the inventor of the formula (now living in China), and how its adoption led to the chronic mispricing of risk that toppled some of the largest banks.
Posted by: lotro cd key | June 16, 2009 at 12:20 AM
Explain the subtleties about how this equation works and how it doesn't, but the problem with pricing models is that they can be abused to boost someone's bottom line on paper. People can abuse this pricing model by using it when it should not be used.
David From the Deeper Voice Blog
Posted by: David | July 30, 2009 at 11:06 AM
We are in search of product and service reviewers to work from home. You need basic computer and internet skills and the ability to follow directions.
Posted by: grow taller 4 idiots | August 18, 2009 at 02:17 PM
Is this the right place to report that this edition of Wired print magazine is entirely unavailable (study of 15 newsagents and 5 book megastores on 9th March 2009) in Islington, North London?
Posted by: celebs gosip | September 11, 2009 at 09:42 PM
Its really a Quant's job to be able to explain the subtleties about how this equation works and how it doesn't, but the problem with pricing models is that they can be abused to boost someone's bottom line on paper. People can abuse this pricing model by using it when it should not be used
Posted by: Kenali dan Kunjungi Objek Wisata di Pandeglang | September 11, 2009 at 09:47 PM
Television all worked very well on the free model. Distribution is almost free on the internet so creating content is the only cost. Advertising revenue is the key.
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That was excellent thank you.I think its companion is equally good, if not better, only because it speaks of the possible future, instead of probable past.
Posted by: gifts for her | November 04, 2009 at 09:07 PM
I was talking to an old friend last night. Our conversations led to us talking about Collateralized Debt Obligations (CDOs) and Collateralized Mortgage Obligations (CMOs) and the financial crisis. I referred him to this article from Wired Magazine on CDOs, titled Recipe for Disaster: The Formula that killed Wall Street. It does a pretty good job of explaining the CDO problem.
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