Re: Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

From: Christian Huitema <huitema () windows microsoft com>
Date: October 20, 2008 10:36:40 PM EDT
To: "dave () farber net" <dave () farber net>
Subject: RE: [IP] Credit Default Swap (CDS) question and answer

> Despite their apparent
> sophistication, almost everyone seems to have underestimated the
> volatility in the mortgage market.

Volatility? It hardly has anything to do with volatility. In theory,  
aggregation uses the law of big numbers to deal with volatility. If  
you aggregate a large enough number of anything, you reduce the  
standard deviation, thus reduce volatility. However, the problem with  
the dubious mortgage was with the first moment, not the second one. If  
every mortgage in a lot is actually worth 50 or 60% of the nominal  
amount, aggregation does not guarantees that the average converges to  
100%. The more you aggregate, the more likely you are to converge on  
the underlying 50 or 60%, or whatever the actual value is.


-- Christian Huitema








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