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The Formula That Killed Wall Street - The Gaussian Copula - Wired - Felix Salmon

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Einstein and Munroe

 

The Formula That Killed Wall Street - The Gaussian Copula - Wired - Felix Salmon (Updated)

The reference of this post is an article is from Wired magazine (above), it's by Felix Salmon, who you might know from Seeking Alpha, the article is interesting in its depth (it has none!).

The article is being commented upon @ LinkedIn this morning but the commentary reflects a zero level understanding of the Gaussian Copula (the subject of the article), which then maybe reflects why "the wizards of wall street" got it so drastically wrong, its nothing to do with the technique, its just that they did not understand 1) what it is for and 2) how it does what it is for & 3) what it is NOT for!

Comment August 2012

If you follow the logic of the critique on this page (& we @ asymptotix appreciate the input [below]); what you see is that it is the 'sociology' of the models that matters, not the quantitative technique per se; if you like its the game theory of the technique deployment that matters, the Project Management.

There are a myriad of Issues in Model Risk, formally Model Risk is attempting 2 capture the gap between the Model & Reality (which is pointless really since 'Real'-Reality is arguably unkowable); we cannot know what the model of 'perfect fit' would actually look like; we can see reality when it arrives and describe it ex-post (we can derives models of the future from that)! Ex-ante all we have is models. Models cause issues where they are mis-managed & this usually involves stupidity of one sort or another! But where this stupidity is being managed for a second order objective (for gain) by intelligent model practitioners; where erroneous results are knowingly managed by securities sales functions; that is where it all goes wrong. That elephant usually resides in the data centre, if you look at the case experience of the last 4 years.

Removing that elephant is the argument for Open Source Transparency.

Original References (June 2009) < see DISQUS comments below for MORE >

If you want to see how the Gaussian Copula really works and how it should be used try these (from the Asymptotix "How to References Page") http://www.asymptotix.eu/content/economic-risk-capital-how-references;-

Correlation: Pitfalls and Alternatives, Paul Embrechts, Alexander McNeil & Daniel Straumann, Departement Mathematik, ETH Zentrum, 1999;
http://www.math.ethz.ch/~mcneil/ftp/risk.pdf
Modeling Dependencies in Finance using Copulae; Wolfgang Härdle, Ostap Okhrin & Yarema Okhrin, SFB 649 Discussion Paper 2008-043;
http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2008-043.pdf 
Modelling Dependent Defaults: Asset Correlations Are Not Enough! Rudiger Frey, Swiss Banking Institute, University of Zurich. Alexander J. McNeil, Department of Mathematics, ETH Zurich, Mark A. Nyfeler, Investment Office RTC, UBS Zurich, March 9, 2001;
http://www.mathematik.uni-leipzig.de/MI/frey/FreyMcNeilNyfeler.pdf

If you want a really easy, relaxed explanation of the Copula then try this;-
Economic Implications of Copulas and Extremes, Norges Bank, 2008, http://www.norges-bank.no/upload/71737/economic%20implications_pek_02_08.pdf

 

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