To understand the mathematics of correlation better, consider something simple, like a kid in an elementary school: Lets call her Alice. The probability that her parents will get divorced this year is about 5 percent, the risk of her getting head lice is about 5 percent, the chance of her seeing a teacher slip on a banana peel is about 5 percent, and the likelihood of her winning the class spelling bee is about 5 percent. If investors were trading securities based on the chances of those things happening only to Alice, they would all trade at more or less the same price... For five years, Lis 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. His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored. Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Lis formula hadnt expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial systems foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.
Posted on: Mon, 21 Oct 2013 05:32:16 +0000
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