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Gaussian Copula Financial Times: David X. Li (Born in China in The 1960s As

David X. Li is a Chinese-born actuary and quantitative analyst who pioneered the use of Gaussian copula models for pricing collateralized debt obligations (CDOs) in the early 2000s. While his model allowed financial institutions to price previously complex investments, it has been criticized for being fundamentally flawed and contributing to the 2008 global financial crisis. Although Li recognized limitations in his model, it was widely adopted by bankers who may have misinterpreted or misused it.

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104 views1 page

Gaussian Copula Financial Times: David X. Li (Born in China in The 1960s As

David X. Li is a Chinese-born actuary and quantitative analyst who pioneered the use of Gaussian copula models for pricing collateralized debt obligations (CDOs) in the early 2000s. While his model allowed financial institutions to price previously complex investments, it has been criticized for being fundamentally flawed and contributing to the 2008 global financial crisis. Although Li recognized limitations in his model, it was widely adopted by bankers who may have misinterpreted or misused it.

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tpowell55
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David X.

Li (born in China in the 1960s as Chinese: ; pinyin: L Xingln[1]) is a quantitative analyst and a qualified actuarywho in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligations (CDOs).[2][3]The Financial Times called him "the worlds most influential actuary",[1] while in the aftermath of the global financial crisis of 20082009, to which Li's model has been credited partly to blame, [1] [2] his model has been called a "recipe for disaster". [2] Li's paper "On Default Correlation: A Copula Function Approach" [3] (2000) was the first appearance of the Gaussian copulaapplied to CDOs, which quickly became a tool for financial institutions to correlate associations between multiple securities.[2] This allowed for CDOs to be supposedly accurately priced for a wide range of investments that were previously too complex to price, such as mortgages. However in the aftermath of the Global financial crisis of 20082009 the model has been seen as fundamentally flawed and a "recipe for disaster". [2] According to Nassim Nicholas Taleb, "People got very excited about the Gaussian copula because of its mathematical elegance, but the thing never worked. Co-association between securities is not measurable using correlation"; in other words, because history is not predictive of the future, "[a]nything that relies on correlation is charlatanism."[2] Li himself apparently understood the fallacy of his model, in 2005 saying "Very few people understand the essence of the model." [4] Li also wrote that "The current copula framework gains its popularity owing to its simplicity....However, there is little theoretical justification of the current framework from financial economics....We essentially have a credit portfolio model without solid credit portfolio theory." [5] Kai Gilkes of CreditSights says "Li can't be blamed", although he invented the model, it was the bankers who misinterpreted and misused it. [2] Li's paper is called "On Default Correlation: A Copula Function Approach" (2000), published in Journal of Fixed Income, Vol. 9, Issue 4, pages 4354.[3] In section 1 through 5.3, Li describes actuarial math that sets the stage for his theory. The mathematics are from established statistical theory, actuarial models, and probability theory. In section 5.4, he uses Gaussian Copula to measure event relationships, or mathematically, correlations, between random economic events, expressed as:

In layman's terms, he proposes there is a relationship between 2 different but related events i.e. "House A" defaulting and "House B" defaulting are measurable using correlation. While under some scenarios (such as real estate) this correlation appeared to work most of the time, the underlying problem is that history ultimately cannot predict the future. From 6.0 onward, the paper presents experimental results using the Gaussian Copula. The results are favorable to Li's proposal.

David X. Li's Summary


An experienced executive with extensive expertise in risk management, product innovation and modeling for the financial industry. Have successfully managed risk management, quantitative analytics and research, and IT over the past 16 years. Proven leadership skills at building new businesses at leading financial institutions, and managing and mentoring highly skilled risk management and quantitative research and IT teams. Well-developed capability to explain complex products and technical issues to non-technical audiences such as board of directors, executive management, regulators, and customers. A deep thinker and diverse problem solver supported by strong hands-on analytical and quantitative skills developed over many year post-graduate studies and work experience. Specialties Finanical risk management with both investment banking and insurance company, asset/liability management, credit product innovation, financial modeling of credit products (corporate, emerging markets, credit structured products, mortgages and ABS), insurance (variable annuities with guaranteed features, re-insurance and insurance securitization). Sales of complicated products and ideas, and a strong researcher.

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