[p2p-research] How the Derivatives Market Jumped of a Cliff On Its Way to a Party

[marc fawzi]

It turns out that people have been warning about this for a long while,
which is part of the reason the person responsible for the formula (and for
the trillions of dollars in derivatives market growth due to it) was passed
on by the Nobel prize committee.

I located the article I had found earlier this week:

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant

It was basically a gambling formula that worked exceedingly well when
certain "things" in the environment were in confluence and blew up the
minute those things got out of sync somehow.  It's the greatest lesson not
to treat circumstantially strong correlation between independent random
variables as being due to some hidden determinism. That's exactly what the
formula did by boiling down correlation between independent random variables
to a constant.  All such models work great when they do but then suddenly
stop working without warning, like finding a trick to win at a gambling
table over and over again and then suddenly losing all the gains and then
some because the trick stops working and you have no clue why. I've seen
that happen to day traders in the stock market. They develop these unique
theories and make a ton of money but then they start to believe that they've
discovered some kind of hidden determinism and forget that what is random is
random.

So in summary, both great depressions (1929 and 2008)  were due to GAMBLING.

Can we please have an economy withOUT gambling!!!?

Someone should start a movement to demand the closure of all stock markets
and all derivatives market in all global markets. NOW. Enough is enough. The
definition of insanity is doing the same thing twice and expecting different
results. So the world is truly insane, what's new?

I am not sure what attachment the world has to gambling?

What will the effect be of closing down stock markets and derivatives
markets?

Why don't we see a grassroots movement to abolish financial gambling
markets?

Is the cocaine culture of Wall Street what is making traders think they can
conquer randomness? I'm serious. Does cocaine play a key role in Wall
Street's addiction to gambling?

Marc

On Fri, Feb 27, 2009 at 12:15 AM, marc fawzi <marc.fawzi at gmail.com> wrote:

> How the Derivatives Market Jumped of a Cliff On Its Way to a Party
>
> This is based on something I read recently but cannot locate atm....
>
> Someone had come up with a probabilistic formula to estimate the
> probability of risk associated with a given random pool of derivative
> securities. It worked 99% of the time in predicting the probability of risk
> by making the flawed assumption that a high degree of correlation between
> independent random variables (across different types of derivatives) was
> actually expressing some hidden causality (some magic in the way nature
> worked that no one had yet understood) when in fact all it was expressing
> was a very high degree of correlation between completely independent random
> variables.
>
> When statisticians play physicist they use the term "copula" which is the
> bundling of independent random variables with high correlation into a
> constant. This "copula" method assumes that there is some hidden causality
> that no one really understands but that can be used to calculate with high
> certainty the probability of risk associated with a random pool of
> derivative securities each with it's own set of independent random
> variables, without analyzing each derivative security individually, and
> without having to put only derivatives of the same type in the same pool. As
> if statistics had found some hidden causality in nature, which happens all
> the time, e.g. Gaussian distribution is common in nature but not universal
> yet it is assumed to be universal by some statisticians as if it's a
> physical law. In other words, high degree of correlation is often confused
> with causation or is taken to be hidden causation in order to simplify some
> probabilistic calculation (at the expense of misleading the user.)
>
> So bankers were able to bundle all sorts of derivatives into the same pools
> and rate them together using the said magic formula, which allowed a massive
> increase in the volume of trading in securities (went from double digit
> billions to double digit trillions in just over 10 years.)
>
> When the market conditions changed this copula (or assumed hidden
> causality) went out of the window and the magic formula's ability to predict
> the probability of risk associated with pools of derivatives went out of the
> window with it. So what we ended up with were credit securities pools that
> were rated AAA but had dog shit in them.
>
> ~~
>
> That satisfies my personal curiosity as to what happened.
>
> It could have been avoided if the person responsible for the now-infamous
> derivatives valuation formula did not treat causality (or lack of) in such a
> shallow and stupid way.
>
> Some kids have an imaginary friend. Some statisticians have an imaginary
> universe.
>
> Marc
>
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