Do CDS price changes imply change in Risk

Felix Salmon’s article in Wired on The Formula, a Gaussian Copula used by Wall St. to price the exotic intruments, which have subsequently led to the Financial Meltdown clearly lays out the genesis and the problems with the development of the models used for building these CDOs.

However there was a particular sentence which I find hard that anyone reporting about the Financial Industry still believes

When the price of a credit default swap goes up, that indicates that default risk has risen.

This is like saying that the daily gyrations in the Forex markets somehow imply that the country’s fundamentals have changed.

This may be true in a theoretical sense but usually it’s simply the noise of the market trading on milions of transactions and has no real meaning in the real world.

It’s time we linked back the vertiginous world of finance to the real one.


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