Recipe for Disaster: The Formula That Killed Wall Street

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investorzzo's picture
investorzzo
Status: Diamond Member (Offline)
Joined: Nov 7 2008
Posts: 1182
Recipe for Disaster: The Formula That Killed Wall Street

 

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott
wrote that "the correlations between financial quantities are
notoriously unstable." Wilmott, a quantitative-finance consultant and
lecturer, argued that no theory should be built on such unpredictable
parameters. And he wasn't alone. During the boom years, everybody could
reel off reasons why the Gaussian copula function wasn't perfect. Li's
approach made no allowance for unpredictability: It assumed that
correlation was a constant rather than something mercurial. 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 them that it was not suitable for use in risk management or
valuation.

In hindsight, ignoring those warnings looks foolhardy. But at the
time, it was easy. Banks dismissed them, partly because the managers
empowered to apply the brakes didn't understand the arguments between
various arms of the quant universe. Besides, they were making too much
money to stop.

 

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant

machinehead's picture
machinehead
Status: Diamond Member (Offline)
Joined: Mar 18 2008
Posts: 1077
Re: Recipe for Disaster: The Formula That Killed Wall Street

This is a very interesting article. Thanks for posting it.

The
article describes how a formula which derived a default correlation
from Credit Default Swap prices was used to price CDO tranches. Since
CDSs only became popular in this decade, the available price history
was short -- only a few years. But even worse, market players assumed
that the correlation derived from the formula was fixed.

This
is an easy mistake to make. Years ago, I read a paper which said that
the correlation between stocks and bonds is 0.19. In practice, bonds
tend to lead stocks throughout the business cycle. In a recession --
for instance, during 2008 -- bonds rise while stocks fall. Then in the
early stage of recovery -- say 2010 -- bonds and stocks rise together.
Later still, as inflation heats up, bond prices peak and begin to
retreat, while stocks carry on rising in the late stage of economic
expansion. Overall, this pattern produces a weak positive correlation
of 0.19. But on a month-to-month basis, depending on the stage of the
business cycle, the correlation can range from strongly negative to
strongly positive.

According to the article, quants who
understood the limitations of assuming a constant correlation weren't
in charge of asset allocation. Instead, thick-necked Wall Street
traders -- your inarticulate, loud-mouthed, bull-headed Hank Paulson
types -- were pounding the table to crank out CDOs. One correlation
number sounded just fine to them -- Keep It Simple, Stupid.

In a
larger sense, classical economics is all static rather than dynamic.
Take a static supply curve, cross it with a static demand curve, and
voila -- you get a clearing price. Forecasting dynamic shifts in these
curves over time is completely beyond the realm of classical economics.
Dynamic economics -- diagnosing the stage of the business cycle, and
its next turn -- is a very underdeveloped field with few competent
practitioners.

What's unbelievable is that there has been no
reform. Although there's little demand for them, Wall Street can still
sell CDOs today, using the same hinky mathematics. Rating agencies
still can rate them AAA, if they choose to do so. The horses have left
the barn, but the Senate's silver-maned gentleman farmers are still
quaffing hot toddies on the veranda, bragging expansively about their
long-gone thoroughbred stallions. Yeah, I'm talkin' to you, Chris Dodd,
you puffed-chest, stuffed-shirted phony.

horstfam's picture
horstfam
Status: Bronze Member (Offline)
Joined: Sep 6 2008
Posts: 71
Re: Recipe for Disaster: The Formula That Killed Wall Street

Hi, machinehead,

You mention that there are some competent practitioners "who get it" today. Do you have the names of any of these guys (or gals) and what are they saying today? I want to believe that there are people out there who do understand where we are in a cycle and are able to somewhat accurately predict where we are headed- with some degree of specificity (not like: off a cliff, for example). Many thanks, in advance.

 

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