Get A Rope!
The CBC reports on the Chinese-Canadian mathematician who created the concept at the heart of the world economic meltdown, David Xiang Li, Wall Street “quant” behind “the Gaussian copula function applied to default correlations” that convinced all of the financial types that the derivatives were low risk.
Interesting article, which touches on the fact that Li’s work wasn’t understood and was abused to produce the necessary models that told the gamblers what they wanted to hear: mega-profits with micro-risk. Obviously the banksters would love to find someone else to blame for their stupidity and greed.
The basic problem of attempting to use mathematics to model market behavior is that there is no way to accurately quantify emotion. The widespread use of computerized trading almost guarantees a cascading effect if the market makes a big move in any direction. The market can swing wildly if someone has a “hunch” and acts on it, or if someone decides to game the system because people are tense.
2 comments
yes, virginia, there really are black swans.
actually you probably don’t really need to quantify emotion, so much as you need to recognize that it exists and that it will exert an influence, then you need to connect the right [possibly unintutive] events together in the right [possibly unintuitve] sequence.
one of things i’ve noticed about math whiz kids is that some of them admire the elegance of equations to the point that they really can’t see where their models deviate from the real world that they’re modeling.
On of the things you learn when you are creating codes is that while the probability that a particular code will be broken on any given attempt approaches zero as the the complexity increases, you can’t achieve zero, and the first attempt may be the one that works.
The existence of life is highly improbable, but, it happened.
Part of what is left out is that the more the model is used, the probably of failure increases. What would have been reasonable with a single, limited context, obviously didn’t scale, and it obviously didn’t foresee the several layers that were added to the original security.
They were selling derivatives of derivatives. It was a pyramid scheme that was dependent on people believing that they were buying something of value, when they weren’t.
What happened wasn’t a Black Swan, an unknown unknown, it was a totally predictable, and predicted, event that had occurred in the past as result of unrestrained financial markets and over-leveraged players.