Tuesday, August 19, 2008

Faulty premise at the heart of credit derivative mathematical model

"In 1997, nobody knew how to calculate default correlations with any precision. Mr. Li's solution drew inspiration from a concept in actuarial science known as the "broken heart": People tend to die faster after the death of a beloved spouse. Some of his colleagues from academia were working on a way to predict this death correlation, something quite useful to companies that sell life insurance and joint annuities."Suddenly I thought that the problem I was trying to solve was exactly like the problem these guys were trying to solve," says Mr. Li. "Default is like the death of a company, so we should model this the same way we model human life."

There are serious problems with this approach. First, the existence of a meaningful analogy between the relationship of a married couple and connections between complex legal/financial structures seems unlikely.

A related post: This is No Longer Funny...by Paul Wilmott.

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