Saturday, 28 February 2009

The real cause of the crisis

Read this very interesting article from Wired Magazine. It argues that a formula devised by David Li, published in an article entitled "On Default Correlation: A Copula Function Approach", may have been at the root of the crisis. The point is that Li's formula allowed analysts to come up with a relatively simple way of pricing risk of portfolios of assets with correlated returns. This in turn allowed the market for the notorious CDOs to develop rapidly. It seems that the tractability of the formula which delivered a simple number is what mattered; the fact that the number may have been built on very dodgy foundations did not matter. (A bit like exam marks perhaps?) Once the number existed, markets could be developed. And everyone used this approach.

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