Reality Isn’t That Simple

Recipe for Disaster: The Formula That Killed Wall Street, is the tale of the Gaussian copula function.  The Gaussian copula function, which determines correlation between “disparate events,” allowed the CDO and credit default swap markets to believe that they correctly priced the risks in complex financial instruments.  The “simple and elegant mathematical formula” was too simple and elegant for the real world, or perhaps the problem was that its simplicity beguiled the market into relying on it too much. But “[t]he relationship between two assets can never be captured by a single scalar quality.” It’s an informative and revealing article, well worth the time.

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