Tuesday, February 24, 2009

Dr. Li's Cupola Formula, the Bond Market, and Wall Street's Meltdown

"Recipe for Disaster: The Formula That Killed Wall Street"
Wired (February 23, 2009)

"A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field...."

According to Wired magazine, quants are "brainy financial engineers" - and one of them, David X. Li, might have gotten a Nobel Prize - if the committee had acted a lot faster.

As it is, Dr. Li seems to be getting credit for bringing Wall Street to its knees.

I don't think that's entirely fair, but a brilliant piece of theoretical mathematics he created did help. Here it is:

(from Wired, used w/o permission)

David X. Li's Gaussian Copula Function: 'It Seemed Like a Good Idea at the Time'

"...It was a brilliant simplification of an intractable problem...."

Just one small problem: it was wrong.

But, investors and bankers loved it. Li's equation could be used to tell how risky a particular sort of investment was. Without spending a lot of time and effort, looking into underlying data.

And, best of all, it was accurate.

Usually. At first.

"...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...."

"...As Li himself said of his own model: 'The most dangerous part is when people believe everything coming out of it.' "

Wired did what seems to be a good job of discussing what happened. If you're interested in the nuts-and-bolts end of economics, I suggest reading the whole article.

I Don't Blame Dr. Li

I think that it's unfair to blame Dr. Li for the meltdown we're watching on Wall Street. Wired is, I think, partly right in their article's title: "The Formula That Killed Wall Street."

I think Wired's third paragraph is spot-on, as far as it goes:

"...His [Dr. Li's] 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...."

There's an old saying, "don't put all your eggs in one basket." Assuming that the Wired article is an accurate, and complete, look at the mess on Wall Street, it looks to me like over-reliance on one method, and letting greed overrule good sense, is what's creating so much exciting economic news.

I'm Taking This Personally

I live on Earth, and use money. That means that what happens in any of the major financial markets will affect me, sooner or later. And, what happened last year went 'way beyond New York City's Wall Street.

On the up side, I've got some wonderful motivation to make my online publishing business work.

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