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The "Model" price is a math model of the probability of a default by the time the CDS expires. This gives you a value "averaged over all possible futures weighted by their respective probabilities".

Most of those math models try to extract "implicit" information from the market...

Implicit information of a model flows from the decision-making structures (schemata) of the model based on the valuation and privileging of the total input stream from what is being modeled.  Baldly, you only see what you're looking for.  

In a mathematical model the problem is compounded¹ by the assumptions of Set Theory as applied in Probability and Statistics.  In the former, a pre-model decision is made to toss all 'unlikely' or low probability occurances into one variable if they are included in the model; in my experience these 'unlikely' occurances are ignored.  

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Jul 4th, 2007 at 12:53:01 PM EST
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Baldly, you only see what you're looking for.  

It's not that bad. When you have a model (produced by scratching you head), and you miss a few calibration parameters, extracting them from the market is like asking around a closed question (answer: yes/no or a single digit, or which box gets checked). In many cases, this actually works very well, pretty safe, and anyway there's no other way you can cope with the volume dealt everyday (I'm thinking of plain vanilla put/call options here, on stocks or currencies).

Like every closed question, it has a preconception of the world. The answer will not tell you that may be you should take a broader perspective and rethink your model because times are changing. You only realize when the results become unstable with time, or you lose money... And then you make the model smarter (like Local Volatility vs. Black-Scholes after the 1987 crash)

The problem is credit derivatives have had no prior "model testing, low volume phase". The bubble brought the volumes to the top tier of the banking business in 5 years.

Pierre

by Pierre on Wed Jul 4th, 2007 at 01:08:38 PM EST
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The use of "Bad" is a value judgement which you, not I, applied.  As you said, "...there's no other way you can cope with the volume dealt everyday ..."  That doesn't imply, however, what is not covered in the model can't hurt you.  (For a given value of hurt.)

This is (1) a subject I'm greatly interested in; (2) can bore people for days discussing; (3) getting way off topic.  


She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Jul 4th, 2007 at 01:49:18 PM EST
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