"Further thoughts on copulas
- Posted by:
- Economist.com | NEW YORK
- Financial markets
OUR RECENT post on the Gaussian copula generated many outstanding comments. Commenter chaintzean offers a defence of the proposition that quants did not appreciate the limitations of their models:
Working as a quant in credit I hear a lot of this "don't blame the formula, blame the people who trusted it wrongfully" argument. I think it's beside the point. The astonishing growth of structured credit was not a consequence of the appearance of quotes based on an oversimplifying formula; it merely facilitated the fulfillment of a growing financial need.
A better statement would go along the line that the gaussian copula was not strong enough a model to prevent a crisis that was already in the making, just like the "pre-smile" option pricing of the 80s cannot itself (or its wrongful use) be held responsible (in a causal sense) for the Black Monday.
The world today is neither much smaller nor less complex than it was before the crisis. While the pricing method will evolve in order to account for the weaknesses of the previous approach, structured credit is bound to come back, in the long run, to levels close to where it was before the crisis; the financial need is still there.
It's a sentiment I've heard from other quants. The argument faults the insatiable demand for the holy grail in investment: predictable, high returns hedged from any downside. It cites the appalling management and cultural divide that exists in many banks. The business side demanded products that could deliver. The quants were charged with creating these perfectly hedged vehicles. Management accepted the products and their stamp of approval from rating agencies. Banks and investors made lots of money and demanded more of the same. There's just one problem: The existing models (and technology) cannot, and perhaps never will, provide a high return and low risk under all circumstances.
You might argue that this only shows these models are dangerous because they promise something they cannot deliver. But that misses the point. They can deliver lower-risk investment at higher returns when used properly. Financial models provide invaluable guidance and information about market risk. But proper use involves accepting a model's limitations and tempering them with good business sense.
I've built financial models under a variety of different management styles. The better managers (who often lacked quantitative skills) asked about the assumptions I made and forced me to explain, in simple terms, what my model did. It was often a painful process, but in retrospect it improved my modeling skills. If some managers at financial firms accepted models blindly, without performing the necessary diligence, then they did not do their job. It does not reflect an innate failure of the model.
To be fair, if such managers did their jobs properly it may have meant putting the breaks on building and selling these products. Chaintzean points this out in another comment:
[F]or a number of structured products the financial need is somehow driven by considerations other than profit or value. For instance, buyers of super-senior protection are sometimes forced into buying for regulatory purpose, almost "at any cost", one might say.
If buyers demand these products at any price, banks are unlikely to eschew them. But I will never understand why banks held these assets on their balance sheets. Surely someone must have known there is no such thing as a high-return-zero-risk investment. If something seems to good to be true, it probably is.
The other comments are great too, I recommend reading the full thread. "