Story of a Math Formula

Question: Math formula most likely to be found in the next edition of Trivial Pursuit

Answer: The Gaussian copula function

For a lesson in applied math, check out this article from Wired Magazine "Recipe for Disaster: The Formula that Killed Wall Street." It tells the story of the housing market's collapse from the perspective of a mathematical formula developed by a financial economist named David X. Li.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

By Michael Alison Chandler  |  March 2, 2009; 1:31 PM ET
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Thank you for the link, Michael. It is an interesting story. Perhaps not the best example of the ways math can affect our lives but certainly one of the more important...

Posted by: fedbert | March 2, 2009 9:41 PM | Report abuse

The formulaic approach to the financial markets eventually always fails. There is a good book called "When genius fails" that is very good and related to this topic. Read that and then read "liar's Poker". Those in combination will illustrate the one thing that is missing from any formulaic approach to the markets - the human factor.

Posted by: ggartner | March 3, 2009 6:20 PM | Report abuse

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