Location: Georgia Southern University, Georgia, United States

Tuesday, September 13, 2005

How Soon We Forget

George Santayana wrote, "Those who cannot remember the past are condemned to repeat it." (Life of Reason, Reason in Common Sense, Scribner's, 1905, page 284)

And so they do. On Monday, September 12, 2005, the Wall Street Journal carried a front page column titled, "How a Formula Ignited Market That Burned Some Big Investors." The story is about how a mathematical computer model used to price exotic credit derivatives based on correlations failed to capture the way the market actually responded to events in the credit market. The fault lies with both the model and its users, but the result was big money lost.

How soon we forget. It was only a few years ago that Long Term Capital Management was arbitraging credit markets with a sophisticated mathematical computer model based on correlations that failed to capture the way ... well, you know the rest of the story.

Models of markets can never be 100% accurate and are always the product of underlying assumptions that may or may not correspond to how the market reacts. Blind faith in their ability to work is a bad habit, and apparently a difficult one to break.

So the next time someone tells you he has heard of a mathematical computer model that uses correlations to arbitrage credit markets remember what Yogi Berra said, "This is like deja vu all over again."


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