
But then I read an interesting article by Felix Salmon in Wired called "Recipe for Disaster: The Formula That Killed Wall Street" that put my concerns into perspective. It's about some model that some dude on Wall Street made up to price opaque securities:
For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.
I don't mean to post any spoilers, but let me just say up front that Wall Street dies at the end. Now, is that all Li and his formula's fault? Well no... as the article eventually makes clear. Any model has assumptions/parameters/initial conditions and what-have-you that have to be fully understood before they can be appropriately applied. Indeed, as an article from waaaay back in 2005 concluded the last time this formula's misbegotten reputation as a magic bullet was being called into question:
This wasn't really the fault of the model, which was designed mainly to help price the tranches, not to make predictions. True, the model had assumed the various credit curves would move in sync. But it also allowed for investors to adjust this assumption -- an option that some, wittingly or not, ignored.As far as I can tell, nobody is calling into question Li's math... or saying he flubbed something or made it all up... they're upset that their misapplication and misunderstanding of his work only made them fabulous amounts of wealth for a few years... before destroying our entire economy.
Whoops? I'd have more Schadenfreude about chickens coming home to roost if we all didn't end up paying for their mistakes.
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