Recipe for Disaster: The Formula That Killed Wall Street
If you like finance and have even a passing interest in math (there must be one or two more of you out there), you’ll find this article fascinating. It attempts to explain on a high level the mathematical fallacies that were overlooked and led traders to assume they had tranched away risk when in fact, they had not.
Li’s copula function was used to price hundreds of billions of dollars’ worth of CDOs filled with mortgages. And because the copula function used CDS prices to calculate correlation, it was forced to confine itself to looking at the period of time when those credit default swaps had been in existence: less than a decade, a period when house prices soared. Naturally, default correlations were very low in those years. But when the mortgage boom ended abruptly and home values started falling across the country, correlations soared.
Source: Wired
