David X. Li
Encyclopedia
David X. Li is a quantitative analyst
and a qualified actuary
who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligation
s (CDOs). The Financial Times
called him "the world’s most influential actuary," while in the aftermath of the Global financial crisis of 2008–2009, to which Li's model has been credited partly to blame, his model has been called a "recipe for disaster".
during the 1960s; his family had been relocated during the Cultural Revolution
to a rural village in southern China for "re-education". Li was talented and with hard work he received a master's degree in economics
from Nankai University
, one of the country’s most prestigious universities. After leaving China in 1987 at the behest of the Chinese government to learn more about capitalism
from the west, he earned an MBA
from Laval University in Quebec
and a PhD
in statistics from the University of Waterloo
in Ontario
. At this point he changed his name to David X. Li. His financial career began in 1997 at Canadian Imperial Bank of Commerce
, and by 2003 he was director and global head of credit derivatives
research at Citigroup
. In 2004 he moved to Barclays Capital
and headed up the credit quantitative analytics
team. In 2008 Li moved to Beijing
where he works for China International Capital Corporation as head of the risk management
department.
. 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 2008–2009 the model has been seen as fundamentally flawed and a "recipe for disaster". 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 past history is not predictive of the future "[a]nything that relies on correlation is charlatanism."
Li himself apparently understood the fallacy of his model, in 2005 saying "Very few people understand the essence of the model." 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." Kai Gilkes of CreditSights says "Li can't be blamed", although he invented the model, it was the bankers who misinterpreted and misused it.
, Vol. 9, Issue 4, pages 43–54.
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 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 past 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.
Quantitative analyst
A quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
and a qualified actuary
Actuary
An actuary is a business professional who deals with the financial impact of risk and uncertainty. Actuaries provide expert assessments of financial security systems, with a focus on their complexity, their mathematics, and their mechanisms ....
who in the early 2000s pioneered the use of Gaussian copula models for the pricing of collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s (CDOs). The Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....
called him "the world’s most influential actuary," while in the aftermath of the Global financial crisis of 2008–2009, to which Li's model has been credited partly to blame, his model has been called a "recipe for disaster".
Biography
Li was born as Li Xianglin and raised in a rural part of ChinaChina
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...
during the 1960s; his family had been relocated during the Cultural Revolution
Cultural Revolution
The Great Proletarian Cultural Revolution, commonly known as the Cultural Revolution , was a socio-political movement that took place in the People's Republic of China from 1966 through 1976...
to a rural village in southern China for "re-education". Li was talented and with hard work he received a master's degree in economics
Master of Economics
A Master's Degree in Economics is a postgraduate academic program, offering training in economic theory, econometrics and / or applied economics. The degree may be offered as a terminal degree or as additional preparation for doctoral study, and is sometimes offered as a professional degree...
from Nankai University
Nankai University
Nankai University , commonly known as Nankai, is a public research university based in Tianjin on mainland China. Founded in 1919 by educators Zhang Boling and Yan Fansun , Nankai University is a member of the Nankai serial schools. It is the alma mater of former Chinese Premier and key historical...
, one of the country’s most prestigious universities. After leaving China in 1987 at the behest of the Chinese government to learn more about capitalism
Capitalism
Capitalism is an economic system that became dominant in the Western world following the demise of feudalism. There is no consensus on the precise definition nor on how the term should be used as a historical category...
from the west, he earned an MBA
Master of Business Administration
The Master of Business Administration is a :master's degree in business administration, which attracts people from a wide range of academic disciplines. The MBA designation originated in the United States, emerging from the late 19th century as the country industrialized and companies sought out...
from Laval University in Quebec
Quebec
Quebec or is a province in east-central Canada. It is the only Canadian province with a predominantly French-speaking population and the only one whose sole official language is French at the provincial level....
and a PhD
Doctor of Philosophy
Doctor of Philosophy, abbreviated as Ph.D., PhD, D.Phil., or DPhil , in English-speaking countries, is a postgraduate academic degree awarded by universities...
in statistics from the University of Waterloo
University of Waterloo
The University of Waterloo is a comprehensive public university in the city of Waterloo, Ontario, Canada. The school was founded in 1957 by Drs. Gerry Hagey and Ira G. Needles, and has since grown to an institution of more than 30,000 students, faculty, and staff...
in Ontario
Ontario
Ontario is a province of Canada, located in east-central Canada. It is Canada's most populous province and second largest in total area. It is home to the nation's most populous city, Toronto, and the nation's capital, Ottawa....
. At this point he changed his name to David X. Li. His financial career began in 1997 at Canadian Imperial Bank of Commerce
Canadian Imperial Bank of Commerce
The Canadian Imperial Bank of Commerce is one of Canada's chartered banks, fifth largest by deposits. The bank is headquartered at Commerce Court in Toronto, Ontario. CIBC's Institution Number is 010, and its SWIFT code is CIBCCATT....
, and by 2003 he was director and global head of credit derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
research at Citigroup
Citigroup
Citigroup Inc. or Citi is an American multinational financial services corporation headquartered in Manhattan, New York City, New York, United States. Citigroup was formed from one of the world's largest mergers in history by combining the banking giant Citicorp and financial conglomerate...
. In 2004 he moved to Barclays Capital
Barclays Capital
Barclays Capital is a global British investment bank. It is the investment banking division of Barclays plc which has a balance sheet of over £1.2 trillion . Barclays Capital provides financing and risk management services to large companies, institutions and government clients. It is a primary...
and headed up the credit quantitative analytics
Quantitative analyst
A quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
team. In 2008 Li moved to Beijing
Beijing
Beijing , also known as Peking , is the capital of the People's Republic of China and one of the most populous cities in the world, with a population of 19,612,368 as of 2010. The city is the country's political, cultural, and educational center, and home to the headquarters for most of China's...
where he works for China International Capital Corporation as head of the risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
department.
CDOs and Gaussian copula
Li's paper "On Default Correlation: A Copula Function Approach" (2000) was the first appearance of the Gaussian copula applied to CDOs, which quickly became a tool for financial institutions to correlate associations between multiple securitiesSecurity (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
. 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 2008–2009 the model has been seen as fundamentally flawed and a "recipe for disaster". 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
Correlation
In statistics, dependence refers to any statistical relationship between two random variables or two sets of data. Correlation refers to any of a broad class of statistical relationships involving dependence....
"; in other words because past history is not predictive of the future "[a]nything that relies on correlation is charlatanism."
Li himself apparently understood the fallacy of his model, in 2005 saying "Very few people understand the essence of the model." 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." Kai Gilkes of CreditSights says "Li can't be blamed", although he invented the model, it was the bankers who misinterpreted and misused it.
Li's paper
Li's paper is called "On Default Correlation: A Copula Function Approach" (2000), published in Journal of Fixed IncomeJournal of Fixed Income
The Journal of Fixed Income is a quarterly academic journal that covers quantitative research on fixed income instruments: mortgage-backed securities, high-yield debt, municipal bonds, corporate bonds, asset-backed securities, and global bonds. Its editor-in-chief is Stanley J. Kon and its...
, Vol. 9, Issue 4, pages 43–54.
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 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 past 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.