The story begins in the late 1970s and early 1980s when this idea starts becoming popular in the mathematicians that they have the power and the brains to model financial markets. Soon this idea also get popular on Wall Street who hired math geniuses to model financial markets. The idea was to model the markets and become rich. The end result? Stock market crash of 2008 in which trillions of dollars were lost. This article Recipe For Disaster: The Formula That Killed Wall Street by Felix Salmon is a must read.
This is the story of David X. Li a maths genius, a quantitative analyst and a qualified actuary who developed the Gaussian copula function. At that time this formula was hailed as a financial breakthrough that would help traders to sell huge quantities of new securities and help expand the financial markets at an exponential pace. This formula quickly became the most favorite quantitative modelling formula being used by bond investors, Wall Street firms, rating agencies and even the regulators. Soon this formula became so entrenched in the Wall Street thinking that suggestions about it’s fallibility were ignored by everyone there. No one on the Wall Street was willing to accept that this formula had severe limitations. The end result was the famous stock market crash of 2008. Today, this formula is being blamed for causing the stock market to crash in 2008 and cause trillions of dollar losses to investors. Felix Salmon explains what happened and how this formula was used by the bond market that caused the ultimate collapse of the financial markets.
People like David X. Li are known as quants and most of them get hired by the Wall Street firms and big hedge funds in an effort to develop mathematical models that can be used to predict the financial markets. We believe markets to be highly unpredictable. No matter how complex the mathematical formula, it will never be able to model the markets. The best traders and investors are those who use simple common sense when making their trading decisions. They win most of the time.