15 - Epilogue

Summary

The Credit Crisis that erupted in Summer 2007, leading eventually in September 2008 to a full-blown Financial Crisis, has led to many questions about the role of quantitative models in the financial industry and whether they were (and still are) being used to provide an illusory crutch to highly risky trading activities. It is worth noting the origin of the crisis is in mortgage-backed securities (MBS), which is the least quantitatively modeled and academically studied of all derivatives markets. Nonetheless, one can suspect that the niceties of risk-neutral pricing, the arbitrage-free equivalent martingale measure, particularly as a formal justification for mark-to-market, were over-extended from liquid options and fixed income markets into unregulated and poorly understood high-dimensional credit markets.

We saw in the previous chapter that, in the CDO arena, before the crisis, the market valued tranches as if there was a high probability of a small number of losses, a small probability of around 10% being lost over the five years, and a relatively high probability of a larger number of losses around 20%. The market's distribution seems to be double-humped. It seems natural that some of the prices or spreads seen in credit markets today are due to “crash-o-phobia” in a relatively illiquid market, with the effect enhanced in large baskets.