Saturday, March 14, 2009

Formula for Disaster


On a day when when leading market indices showed a momentary albeit minor reversal of their downward spiral, lets ask how we got here.. Felix Salmon has a piece in this month's Wired on the financial tool that may have been at the root of all that irrational exuberance, the Gaussian copula function.


 David X. Li, formulated the GPC. His equation reduced the statistical chaos of finding correlations in financial data to a single expression with few variables. For some time Li's brain child produced amazing results despite its simplicity. However, it was fatally flawed. Li based the formula on inferences taken from a decade of continuous growth. Such optimistic projections ignored real world downturns. No one saw the flaws because they took the formula as an article of faith.

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