Monday, February 22, 2010

Lo-down

Had my eyes dilated this afternoon so I ended up watching Andrew Lo of MIT show you how to make gloss out of dross.

The story is pretty old, but if you want a simple and easy to understand mathematical example of how securitization works, this is your man.  He illustrates how you can take two risky mortgages, stick them together, assume they are statitically independent and create one big safe bond and one small hunk of shit.  One thing I hadn't ever considered is that you were able to bet directly on the correlation between the two initial bonds being higher than people thought.  In retrospect it's obvious, the structure is designed to exploit the assumed statistical independence of the bond, so if you reverse engineer it, by going long the shit and short the AAA piece, there's free money to be made by violating the initial assumption.  He explains it better in the video though.



2 comments:

ac said...

Wow the bit that went up was sold to hedge funds, and the bit that went down was sold to pension funds? What a strange coincidence!

Clark said...

Well, it was "sold to" pension funds, but "bought by" hedge funds. Admittedly though, a good lesson in staying at the top of the food chain.