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What Concepts Are the Most Dangerous Ones in Quantitative Finance Work?

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There are a few things that form the common canon of education in (quantitative) finance, yet everybody knows they are not exactly true, useful, well-behaved, or empirically supported.

So here is the question: which is the single worst idea still actively propagated?

Please make it one suggestion per post.

Dirk Eddelbuettel

Answer:

Correlation

Correlations are notoriously unstable in financial time series – yet one of the most used concepts in quant finance because their is no good theoretical substitute for it. You could say theory is not working with it yet neither without it.

For example the concept is used for diversification of uncorrelated assets or for the modelling of credit default swaps (correlation of defaults). Unfortunately when you need it most (e.g. a crash) it just vanishes. This is one of the reasons that the financial crises started because the quants modeled the cds’s with certain assumptions concerning default correlations – but when a regime shift happens this no longer works.

vonjd

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