Copula Functions and the Current Crisis
| Nicolai Foss |
Forget about effective demand failures, malinvestments caused by expansionary monetary policy, or even political regulation of the US housing market: The true bete noire in the current meltdown is a specific copula function (here is the Wiki on copulas), or more precisely David Li’s application of it to the modeling of default correlation (here). Or, so Wired claims. Writer Felix Salmon is pretty explicit in his condemnation of Li’s approach:
It was a brilliant simplification of an intractable problem. And Li didn’t just radically dumb down the difficulty of working out correlations; he decided not to even bother trying to map and calculate all the nearly infinite relationships between the various loans that made up a pool. What happens when the number of pool members increases or when you mix negative correlations with positive ones? Never mind all that, he said. The only thing that matters is the final correlation number — one clean, simple, all-sufficient figure that sums up everything.
Apparently, major finance academics — like Darrell Duffie — had warned against the application of Li’s work.
I am by no means competent to pass any judgment on Salmon’s story. I merely recommend it as a highly interesting read — and wonder how long it will take before the performativity-in-financial-markets-crowd picks it up. Actually, it may rather support the Felin & Foss argument that false social constructions are eventually weeded out (here).