‘The formula that killed Wall Street’: The Gaussian copula and modelling practices in investment banking

Abstract

Drawing on documentary sources and 114 interviews with market participants, this and a companion article discuss the development and use in finance of the Gaussian copula family of models, which are employed to estimate the probability distribution of losses on a pool of loans or bonds, and which were centrally involved in the credit crisis. This article, which explores how and why the Gaussian copula family developed in the way it did, employs the concept of 'evaluation culture', a set of practices, preferences and beliefs concerning how to determine the economic value of financial instruments that is shared by members of multiple organizations. We identify an evaluation culture, dominant within the derivatives departments of investment banks, which we call the 'culture of no-arbitrage modelling', and explore its relation to the development of Gaussian copula models. The article suggests that two themes from the science and technology studies literature on models (modelling as 'impure' bricolage, and modelling as articulating with heterogeneous objectives and constraints) help elucidate the history of Gaussian copula models in finance.

The Business Intelligence as a Service in the Cloud

“…His model could work on the desktop and results could be calculated for an acceptable amount of time. However, his model did not check risks properly and did not have any suggestions to counter risks when extreme events happened [1]. Here is a real story describing the background that lead to the development and widely adoption of "Gaussian copula" and our proposal to rectify problems caused by this model.…”

“…Often activities of large-scale software simulation to calculate risk and pricing take hours without simplifying the model [1]. Simplification of model was used in finance industry for some time prior 2008 crisis.…”

“…Li then combined a popular financial software, CreditMetrics, and Copula function together to establish "Gaussian copula" model, which has been used by the finance industry since 1997 [1]. The "Gaussian copula" model is often called as CDO solution, since it is a term easily understood by the finance sector.…”

Introduction to the Risk Visualization as a Service

“…Volume 1, Issue 1, 2014 www.ronpub.com/ojcc ISSN 2199-1987 the tendency of underestimating the risk [4], [11]. Some researchers believe that it was the greed of the bankers who misused the model and led into financial crisis [11].…”

“…Some researchers believe that it was the greed of the bankers who misused the model and led into financial crisis [11]. Nevertheless, all these factors contribute to the financial crisis.…”